Moonstay Corporation

Please, answer questions #1 and #2 only.

I attached the whole assignment but only need answer for question #1 and #2.

I also attached the book so you can use it as reference (The Scheutze speech is at p. 226 of the text).

Moonstay Corporation Case Instructions

1. Answer all 5 questions, including all subparts at the end of the case.

2. Make sure to use the course readings, including the Numbers Game Speech, in your answers. The case does focus on earnings management manipulation.

3. You may do outside research to assist in answering the questions.

Mark-to-market Accounting

This thought-provoking and immensely readable collection of articles, speeches and
letters by Walter Schuetze, one of the world’s most distinguished accounting
practitioners, is a work for our time.

In the wake of the largest surprise corporate failures and retrospective financial
restatements in corporate history, Walter Schuetze and Peter Wolnizer (as editor) turn
their attention to what they call the syndrome of “Enronitis.”

They contend that the unheralded collapse of companies such as Enron and
WorldCom in the USA, and HIH Insurance in Australia, shows the failure of
conventional accounting and auditing practices to provide high-quality financial
information for investors as intended by law. It is little wonder, therefore, that
public confidence in financial reporting, auditing and corporate regulation is at an
all-time low.

This book argues that it is time to base financial reports on up-to-date prices —
current selling prices for assets and current settlement prices for liabilities— and to
disclose the details of those who provide the market price data.

In this strongly practical case for mark-to-market accounting, the authors
demonstrate how such a regime would put a stop to earnings management and
establish a firm financial foundation for corporate governance and independent
auditing. Providing nothing less than “true north” in financial reporting.

This book will be essential reading for advanced students and academics in the field
of accounting.

Walter P.Schuetze is a certified public accountant. He was chief accountant to the
Securities and Exchange Commission (1992–5) and chief accountant of the
commission’s Enforcement Division (1997–2000).

Peter W.Wolnizer is dean of the Faculty of Economics and Business and a
professor of accounting in the University of Sydney. He is author of Auditing as
Independent Authentication and has written extensively on financial accounting and
auditing.

Routledge New Works in Accounting History
Series editors: Richard Brief, Leonard N.Stern School of Business, New York
University; Garry Carnegie, Deakin University, Australia; John Richard Edwards,
Cardiff Business School, UK; Richard Macve, London School of Economics, UK

The Institute of Accounts
Stephen E.Loeb and Paul J.Miranti

Professionalism and Accounting Rules
Brian P.West

Accounting Theory
Essays by Carl Thomas Devine
Edited by Harvey Hendrickson and Paul Williams

Mark-to-market Accounting
“True north” in financial reporting
Walter P.Schuetze, edited by Peter W.Wolnizer

Mark-to-market Accounting

“True north” in financial reporting

Walter P.Schuetze,

edited by Peter W.Wolnizer

LONDON AND NEW YORK

First published 2004
by Routledge

11 New Fetter Lane, London EC4P 4EE

Simultaneously published in the USA and Canada
by Routledge

29 West 35th Street, New York, NY 10001

Routledge is an imprint of the Taylor & Francis Group

This edition published in the Taylor & Francis e-Library, 2005.

“To purchase your own copy of this or any of Taylor & Francis or Routledge’s collection of
thousands of eBooks please go to www.eBookstore.tandf.co.uk.”

mechanical, or other means, now known or hereafter invented,
including photocopying and recording, or in any information

storage or retrieval system, without permission in writing
from the publishers.

British Library Cataloguing in Publication Data
A catalogue record for this book is available from the

British Library

Library of Congress Cataloging-in-Publication Data
A catalog record for this title has been requested

ISBN 0-203-63399-7 Master e-book ISBN

ISBN 0-203-63739-9 (Adobe eReader Format)
ISBN 0-415-29955-1 (Print Edition)

To our wives Jean and Gaye

Contents

Notes on author and editor ix

Foreword xi

Letter from Fred Talton xiii

Acknowledgments xiv

1 Walter P.Schuetze: accounting reformer
PETER W.WOLNIZER

2 Autobiography
WALTER P.SCHUETZE

PART I Accounting for assets and liabilities 32

3 Schuetze on accounting for assets and liabilities
PETER W.WOLNIZER

4 Keep it simple 46

5 What is an asset? 52

6 What are assets and liabilities? Where is true north?
(Accounting that my sister would understand)

7 New chief accountant’s wish list 85

8 Relevance and credibility in financial accounting and
reporting

9 Why are we all here anyway? 99

10 Accounting for restructurings 103

11 Enforcement issues, and is the cost of purchased goodwill an
asset?

110

12 Cookie jar reserves 115

13 Financial instruments 120

14 Accounting for transfers of receivables (by Tom, Dick, and
Harry)

124

15 Discount rate re cash outflows for nuclear decommissioning
and environmental remediation

132

16 Discount rate for pension liabilities 135

17 Exposure Draft E55: Impairment of Assets 137

18 Exposure Draft E59: Provisions, Contingent Liabilities, and
Contingent Assets

139

19 Exposure Drafts E60: Intangible Assets, and E61: Business
Combinations

142

20 Business combinations and intangible assets 147

21 Accounting for the impairment or disposal of long-lived
assets and for obligations associated with disposal activities

154

22 Business combinations and intangible assets: accounting for
goodwill

157

23 The FASB and accounting for goodwill 161

24 Accounting for financial instruments with characteristics of
liabilities, equity, or both

165

25 Accounting for stock options issued to employees 168

26 Proposed interpretation: guarantor’s accounting and
disclosure requirements for guarantees, including indirect
guarantees of indebtedness of others

174

27 Your proposed interpretation: consolidation of certain
special-purpose entities

175

PART II The implications of accounting practices for auditing 178

28 Schuetze on the implications of accounting practices for
auditing
PETER W.WOLNIZER

179

29 Disclosure and the impairment question 189

30 The liability crisis in the USA and its impact on accounting 196

31 Reporting by independent auditors on internal controls 202

32 A mountain or a molehill? 209

vii

33 Comments on certain aspects of the special report by the
AICPA’s Public Oversight Board of 5 March 1993

218

34 Enforcement issues: good news, bad news, Brillo pads,
Miracle-Gro, and Roundup

226

PART III Accounting standard setting and regulation 234

35 Schuetze on accounting standard setting and regulation
PETER W.WOLNIZER

235

36 The setting of international accounting standards 247

37 What is the future of mutual recognition of financial
statements, and is comparability really necessary? Information
is king

251

38 A note about private-sector standard setting 256

39 Take me out to the ball game 260

40 Financial accounting and reporting in our worldwide
economy

266

41 SEC accounting update 274

42 A review of the FASB’s accomplishments since its inception
in 1973

279

43 Current developments at the SEC 284

44 A memo to national and international accounting and
auditing standard setters and securities regulators (a
Christmas pony)

291

45 Hearing: “Accounting and Investor Protection Issues Raised
by Enron and Other Public Companies: Oversight of the
Accounting Profession, Audit Quality and Independence,
and Formulation of Accounting Principles”

303

46 Watching a game of three-card monte on Times Square 310

47 IASC due process 320

Index 324

viii

Notes on author and editor

Walter P.Schuetze was chief accountant to the Securities and Exchange Commission
(SEC) of the United States of America from January 1992 through March 1995,
when he retired. He was appointed chief accountant of the SEC’s Enforcement
Division in November 1997 and served through mid-February 2000, when he
retired again. He was a consultant to the Enforcement Division from March 2000
through March 2002 on matters involving accounting and auditing.

Mr Schuetze is currently a consultant in various litigations as an expert in
accounting and auditing. He is also an executive in residence in the College of
Business at the University of Texas in San Antonio and a member of the boards of
directors and chairman of the audit committees of Computer Associates
International Inc. and TransMontaigne Inc.

He was a charter member of the Financial Accounting Standards Board, serving as
a member from April 1973 through mid-1976. He was a member then chairman of
the Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants. He was a member of the Steering Committee of the
International Accounting Standards Committee dealing with intangible assets,
business combinations, and impairment of assets. He has delivered occasional
lectures on accounting at the business schools of St Mary’s University in San
Antonio, the University of Texas in San Antonio and the University of Southern
California in Los Angeles.

Walter Schuetze began his career in accounting in 1957 with the public
accounting firm of Eaton & Huddle in San Antonio, which merged with Peat,
Marwick, Mitchell & Co. (now KPMG LLP) in 1958. He was a partner in KPMG
from 1965 to 1973, when he was appointed to the Financial Accounting Standards
Board, and from 1976 to 1992, when he was appointed to the position of chief
accountant to the Securities and Exchange Commission.

He served in the US Air Force from 1951 to 1955. He received a Bachelor of
Business Administration degree, with honors, from the University of Texas at

Austin in 1957. He is a certified public accountant, a member of the American
Accounting Association and the American Institute of Certified Public Accountants,
and a member of the Beta Alpha Psi and Beta Gamma Sigma honorary societies. He
was born on 2 August 1932.

February 2003
Peter Wolnizer is dean of the Faculty of Economics and Business and a professor

of accounting in the University of Sydney, Australia. Previously, he held the
foundation chair of accounting and finance in Deakin University (1989–99), where
he served as foundation dean of the Faculty of Business and Law (1991–99). Prior
to those appointments, he held lecturing positions in the University of New South
Wales (1973–5) and the University of Sydney (1976–87), and a readership in the
University of Tasmania (1987–8). Before entering academic life, he worked for six
years in industry, commerce and the accounting profession.

Professor Wolnizer has also been appointed to visiting professorial or research
fellowship positions by the Universities of Canterbury, Glasgow, Kansas, Pittsburgh
and Utah—most recently as the James Cusator Wards Visiting Professor in the
University of Glasgow (1993 and 1998), Visiting Professor at the Czech
Management Center in Prague (1995), and Visiting Erskine Fellow in the
University of Canterbury (1998).

He is chairman of the Board Education Committee and Professional Education
Board of CPA Australia, the Asia-Pacific member of the Education Policy
Committee of the International Association of Financial Executives Institutes, and a
member of the Research and Publications Committee of the Committee for
Economic Development of Australia (CEDA). He served as a member of the
Council of the Scots College (Sydney) from 1999 to 2002, a member of the
Council of Scotch College (Melbourne) from 1998 to 2001, and a member of
Australia’s Corporations and Securities Panel from 1995 to 1998.

Peter Wolnizer has a Bachelor of Economics degree from the University of
Tasmania, and the degrees of Master of Economics and Doctor of Philosophy from
the University of Sydney He is a Fellow of both CPA Australia and the Institute of
Chartered Accountants in Australia. His fields of expertise are financial accounting,
auditing, and corporate governance. He is the author of Auditing as Independent
Authentication (Sydney University Press, 1987) and editor of five books. His articles
have been widely published in scholarly and professional journals; several having
been reproduced in anthologies, journals and textbooks published in the USA, UK
and Australia.

February 2003

Foreword

Were an anthropologist from Mars to descend upon our financial world, observing
companies presenting their financial positions, what an Orwellian experience it
would be. The language of statutory obligation demands that they give a true and
fair view. Yet there is no explicit obligation for that truth and fairness to be
grounded upon the actuality of current market selling prices for assets and their
reciprocals for liabilities. Our Martian would, if of historical bent, identify precisely
when the rot set in: 1844, when the Joint Stock Companies Act was passed in the
United Kingdom. For that research, we are indebted to the late Professor Ray
Chambers and his former pupil, now professor and dean, Peter Wolnizer, at the
University of Sydney’s Faculty of Economics and Business. He is the thoughtful and
discerning editor of this collection, adding important linking essays of his own.

It is rare to find an intellectual lineage that starts in the 1950s with an Australian
progenitor, Ray Chambers, who pioneered with Walter Schuetze many of these
seminal ideas. They proceeded on largely parallel tracks, like Leibniz and Newton
devising calculus. It must be rarer still to find a disciple, again Australian, who
collaborates with Professor Chambers, then engages in an intense and deeply
reflective exchange with Walter Schuetze in the United States. Those connections
are the intellectual underpinning of Professor Wolnizer’s discerning editorial work,
in which he brings to the Australian context a theme of international importance.
That theme is one of outstanding simplicity, intuitively convincing, yet nowhere
adopted as mandatory policy for corporate reporting. I refer to “mark-to-market
accounting,” so far the preserve only of those parts of a business that invest in
marketable securities.

That Walter Schuetze early in his career studied Russian has, for me, a literary
resonance. Tolstoy wrote a memorable short story about an archetypal character of
Russian literature, the holy simpleton. The story was entitled, as I recall it, “The
Shoemaker.” This was a character of profound simplicity. He is not to be confused
with Chauncey Gardner, the Peter Sellers character in the film Being There, a character

of profound inanity. Tolstoy’s shoemaker gently disarms untruth. He does so by
unselfconscious intuition about what is right, expressed in simple terms; in the
supposedly “real” world, an ingénue. Walter Schuetze is in some respects of that
character, with his Texan directness, collo-quial and jargon-free. For his paradigm is
“accounting my sister would understand.” He is also a person whose personal
character was severely tested when a partner at KPMG. When asked to give auditing
dispensation to the thrifts and saving associations, with their shonky pseudo-
partnerships masquerading as loans, he, with the backing of his firm and at real
cost, simply refused. If only the same had been done with Enron’s audit.

But what impact has Walter Schuetze made in Australia? Some months after a
memorable dinner in the Great Hall at the University of Sydney on 27 November
2001, at which Walter Schuetze gave the R.J.Chambers Memorial Research
Lecture, I was approached by a critic: “this was a very unfortunate affair, did you
not see how uncomfortable some of our invited guests were, especially some of the
accountants, at Schuetze’s radical views?” (I add that most of the accountants there
were full of praise.) For those that would listen, he was telling us that in the world
of corporate emperors many were overdressed; but beneath the Zegna suits they had
no clothes at all.

The critic’s observation, made after Enron had emerged, allowed me the perfect
riposte. It was that Schuetze had shown extraordinary prescience in his appreciation
of what was to come. Those accountants who were skeptical would have done well
to heed his words rather than stone the prophet.

This book is a tribute both to its editor and to those who inspired it, but most
especially to Walter Schuetze. It deserves a wide and discerning audience who take
its message seriously. For what is at stake is nothing less than a fundamental
underpinning of our capitalist system. It is a call, yet to be heeded, for accounts we
can understand, who tell it like it is.

The Honorable Justice G.F.K.Santow, Chancellor, University of Sydney,
31 January 2003

xii

Letter from Fred Talton

The following note, in handwritten form, was received by Walter P.Schuetze in
June 2002 from Fred W.Talton, who was a partner in PMM&Co. in the Raleigh,
North Carolina, office in the 1980s at a time when Mr Schuetze was a partner in
PMM&Co.’s Department of Professional Practice.

2728 Branch Road
Raleigh, North Carolina 27610

28 June 2002

Dear Walter,
As a CPA who retired from PMM&Co. in 1987, I have reflected many times on

various accounting and audit situations that I encountered during my career. In
seeking help in these matters from the Department of Professional Practice, you
were quite often the person that I called on for help. The responses that I received
from you were always well thought out and reasonable, though not always what our
clients wanted to hear. During that period, I felt that, in working with you, I was
always working with the ultimate professional.

Over the years, and especially in the most recent years, I have often thought that
all of our audit partners owe you a real debt of gratitude for being such a
professional in dealing with client matters. I believe some of the thoughtful,
reasonable positions you took have saved the firm and its partners many millions of
dollars and great embarrassment

Please allow me to express my own appreciation and respect for your service.

Sincerely,
Fred W.Talton

Acknowledgments

For his scholarly advice, encouragement and support for this work, we express our
sincerest appreciation to Professor Richard P.Brief of the Leonard N.Stern School of
Business in New York University, an eminent scholar of the history and
development of accounting thought. And we are honored by, and deeply grateful to
the Honorable Justice Kim Santow, a Judge in the Court of Appeal, Supreme Court
of New South Wales, and Chancellor of the University of Sydney, for writing the
foreword.

We acknowledge, with gratitude, the permissions given by publishers to
reproduce in this volume the eight previously published articles and lectures by
Walter P.Schuetze; and the permissions given by Sir Bryan Carsberg and Mr Fred
Talton to reproduce their letters to Walter Schuetze.

Ron Ringer provided invaluable technical and editorial assistance in transforming
dozens of differently formatted documents into the uniform style prescribed by
Routledge, for reading and checking the entire manuscript, and for coordinating the
project. Sincere thanks are also extended to Carl Harrison Ford, Walter P.Schuetze
and Dr Robert R.Sterling for reading and providing constructive comments on the
editorial essays.

We are indebted to the editorial staff of Routledge (London) for their very
helpful advice and ready cooperation in respect of all publishing-related matters.

For the provision of a research grant to support this work, we express our sincere
appreciation to the Accounting Foundation within the University of Sydney.

Permissions

The authors gratefully acknowledge permission to reproduce the following articles
in full:

“Keep it simple,” reproduced by kind permission of Accounting Horizons
American Accounting Association, Vol. 5, No. 2, June 1991, pp. 113–17.

“What is an asset?” reproduced by kind permission of Accounting Horizons,
American Accounting Association, Vol. 7, No. 3, September 1993, pp. 66–70.

“Disclosure and the impairment question,” © 1987 from The Journal of
Accountancy by the American Institute of Certified Public Accountants. Opinions of
the authors are their own and do not necessarily reflect policies of the AICPA.
Reprinted with permission.

“The liability crisis in the US and its impact on accounting,” reproduced by kind
permission of Accounting Horizons, American Accounting Association, Vol. 7, No. 2,
June 1993, pp. 88–91.

“A memo to national and international accounting and auditing standard setters
and securities regulators (a Christmas pony),” 2001 R.J.Chambers Memorial
Research Lecture in the Great Hall, the University of Sydney, Australia, 27
November 2001, reproduced by kind permission of the Accounting Foundation
within the University of Sydney.

“Reporting by independent auditors on internal controls,” reproduced by kind
permission of The CPA Journal, October 1993.

“A mountain or a molehill?” reproduced by kind permission of Accounting
Horizons, American Accounting Association, Vol. 8, No. 1, March 1994, pp. 69–75.

“What are assets and liabilities? Where is true north? (Accounting that my sister
would understand),” Abacus: A Journal of Accounting, Finance and Business Studies,
Vol. 37, No. 1, February 2001, pp. 1–25, Blackwell.

Speeches by Walter Schuetze in his capacity as a member of staff of the SEC are
in the public domain. Letters written by Walter Schuetze are copyright to the
author.

1
Walter P.Schuetze
Accounting reformer

Peter W.Wolnizer

This is a unique and timely work. While pertinent to the era of the modern
corporation, it is especially a work for such a time as this. For corporate financial
reporting and auditing are again sharply under the spotlight of governments and
regulators around the world—this time, in the wake of the most significant
unexpected corporate failures and surprise retrospective financial restatements in
corporate history, a syndrome we call “Enronitis.”

The recent and unheralded failures of Enron and WorldCom in the USA, and of
HIH Insurance, One.Tel, and Ansett in Australia—and the unexpected
retrospective restatements by a large number of public companies in the USA1—
have occurred when, by law, investors, creditors, and others are to be informed truly
and fairly of the up-to-date financial position and performance of the reporting
enterprises. But, again, as we have seen repeatedly in the past, the financial
instrumentation system by which investors and creditors are to be so informed
(financial accounting and reporting), and the quality control system by which the
reliability of that financial instrumentation system is to be assured (auditing), have
failed to provide the reliable and high-quality financial signals and informative
safeguards for the investing public intended by the Corporations and Securities
Laws. The syndrome of Enronitis is not new. In the USA, for example, there were
the unexpected collapses of Equity Funding and Penn Central in the 1970s, and the
savings and loan fiascos of the 1980s and 1990s. In the UK, there was Pergamon in
the 1970s, and Maxwell Corporation and BCCI in the 1990s. In Australia, there
were Reid Murray, Latec Investments, Stanhill, and H.G.Palmer in the 1950s and
1960s; Minsec, Cambridge Credit, Mainline and Associated Securities Ltd in the
1970s; and Bond Corporation, Rothwells, Adsteam, Westmex, and Qintex in the
1990s.2 And those are just a few of the notable corporate catastrophes.

This book addresses the prevalent and recurrent accounting and auditing problems
highlighted again in the most recent corporate financial debacles. It contains an
autobiographical essay and a collection of seven articles, eighteen speeches and

addresses, and sixteen letters written by an eminent accounting practitioner,
standard setter and corporate regulator—Walter P.Schuetze. Though addressed to
diverse, but expert, audiences about specialist and often technically complex
matters, their distinctive, plain English style makes them intelligible to all who are
interested in financial accounting and reporting, and their function in informing
financial decision making and capital markets.

Without drawing on the ideas and work of others, Schuetze sets forth, in a
compelling and highly readable fashion, his ideas about financial accounting and
reporting, auditing, accounting standard setting and corporate regulation. The work
is novel in many respects, most of all perhaps because those ideas evolved
throughout a career in accounting practice spanning more than forty years— many
of them spent at the zenith of the accounting profession (as a partner in KPMG),
accounting standard setting (as a charter member of the Financial Accounting
Standards Board, a member of the Financial Accounting Standards Advisory
Council and chairman of the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants), and securities regulation (as
chief accountant to the Securities and Exchange Commission in the USA and chief
accountant of the Enforcement Division of the Securities and Exchange
Commission). Schuetze’s ideas fundamentally challenge the conventional
accounting and auditing wisdom and advocate deep change and major reform. They
offer a solution to the widely recognized problem of earnings management, and a cure
for Enronitis.

The observations, ideas and arguments contained in this collection are born of
personal experience, an encyclopedic knowledge of accounting and auditing
standards and practices, an analytically incisive mind and a razor-sharp intellect.
They are informed by direct personal observation of what styles of accounting do
and do not work and by a professional passion to improve the quality of financial
accounting and reporting in the interests of better informing capital markets and the
financial decisions of investors and creditors. They are founded on an unshakable
commitment to the highest ideals and standards of professional ethics and personal
integrity. Walter Schuetze is an independently minded and thoughtful man who is
given to measured and informed judgment—a consummate professional, a true
reformer.

Schuetze’s ideas and proposals for accounting and auditing reform are no
recitation of the wisdom of others. His writings contain remarkably few citations or
references. They contain no appeals to authority or support in the academic and
professional literature. Although he is well and widely read, his ideas are shaped by
intuition, common sense, observation and experience. Walter Schuetze’s
distinguished career, professional standing, expertise and strength of character speak
loudly.

His autobiographical essay is highly informative and a delight to read. It reveals
how a boy reared on a farm in south-central Texas was shaped by the education he
received at two small schools, and of the tremendous impact and legacy left to him
by a few highly dedicated teachers. It tells of his early ambition to teach, of his

2 MARK TO MARKET ACCOUNTING

passion for the English and Russian languages developed during his undergraduate
education at the University of Texas at Austin, of his service in the US Air Force
during the Korean War, of his subsequent keen interest in accounting, and of what
was to be an outstanding career—one that, uniquely, spanned accounting practice,
standard setting and regulation at the highest levels. It provides helpful and
fascinating insights into the challenging life and work of a senior practitioner,
standard setter and securities regulator. Importantly, it illuminates the question
“how did you arrive at mark-to-market (market selling price) accounting?” especially
when the idea of market selling price accounting has received little support from the
academic community notwithstanding its rigorous theoretical foundations and,
except for accounting for marketable securities, negligible support from the
practicing profession.

It is my great respect for the ideas and my enjoyment of the style and turn of
phrase in Walter Schuetze’s articles published in Accounting Horizons in the early
1990s, together with my curiosity about how and why such an experienced
practitioner arrived at mark-to-market accounting, that stimulated my quest to
make available in a single volume not only his eight published pieces (seven articles
and the R.J.Chambers Research Lecture) but also his thirty-four hitherto
unpublished speeches, addresses and letters. His writings date from 1986 to 2002,
the majority coinciding with his appointments as chief accountant to the Securities
and Exchange Commission (1992–5) and chief accountant of the Enforcement
Division of the Securities and Exchange Commission (1997–2000).

Following this introduction and an autobiographical essay by Schuetze, the
collection is arranged thematically in three sections as follows:

1 Schuetze on accounting for assets and liabilities;
2 the implications of accounting practices for auditing; and
3 accounting standard setting and regulation.

Apart from the autobiographical piece, each section is prefaced by an editorial
overview of each article, speech, address and letter, essentially in chronological order.
The editorial essays seek to provide a helpful guide to the topical matters under
notice in each document, and to identify major drifts of argument. Drawing on his
vast professional experience, and often writing as chief accountant to the Securities
and Exchange Commission, Schuetze provides fascinating insights into the most
fundamental and current issues confronting accounting standard setters and
securities regulators as they determine and oversee the quality of financial
accounting and reporting and corporate auditing.

The major themes throughout Walter Schuetze’s writings are as follows:

• The function of accounting is to inform financial decision making by investors
and creditors. Consequently, accounting standard setters and corporate
regulators should adopt a “capital markets perspective” in determining the kind

WALTER P.SCHUETZE: ACCOUNTING REFORMER 3

of financial information that should be provided in general-purpose financial
statements.

• Investors and creditors would be better served by a simple, relevant and
transparent style of accounting in which assets are defined in terms of
exchangeability and valued at current market selling prices; and in which
liabilities are defined in terms of legally enforceable claims against an entity and
valued at current settlement prices. Consequently, conventional cost-based
accounting should be replaced by mark-to-market accounting.

• The Securities and Exchange Commission should require public companies to
mark all assets and liabilities to market, and to disclose the names of the persons
or entities that provide the market price data in the financial statements.

• Auditing should entail the gathering of competent evidence of the value of assets
and liabilities from the marketplace, independently of the management of the
reporting enterprise. Consequently, the ethical rules and ideals pertaining to
auditor independence and due care would be transformed— from a singular, but
blurred, focus on the auditor-client relationship to the independence of audit
evidence and testing, and the independence of audit judgment. Auditing would
thus become the rigorous process of independent authentication and control
over the quality of financial reporting that the Corporations and Securities Laws
intend it to be.

• Auditors should carefully guard their social interactions with clients to avoid any
real or apparent threat to their ability to maintain an appropriate level of
professional skepticism.

A call for accounting and auditing reform

The most recent financial imbroglios have caused particular consternation, perhaps,
because of the sheer magnitude of the financial consequences of the corporate
failures already mentioned, and of the retrospective financial restatements of the
likes of Waste Management, Sunbeam, Cendant, Livent, MicroStrategy, and Global
Crossing. Governments and corporate regulators around the world are properly
concerned about the potentially detrimental economic consequences of a
diminution of investor confidence in financial markets occasioned by the failure of
financial reporting and auditing to provide informative, reliable and transparent
financial information as a basis for financial decision making by investors.

No one would attribute corporate failure to accounting per se. Nor are we
suggesting that accounting can prevent corporate failures. Some business enterprises
fail in competitive markets. Rather, the point at issue is that the financial reporting
by these corporations and the auditing of their financial statements failed to provide
factual and up-to-date information about their actual financial position and
solvency at the time of their collapse—and of their financial performance in the
period prior to their collapse. However, it could be that defective accounting
contributed to the magnitude of the financial losses associated with their collapse
and led to involuntary redistributions of wealth.

4 MARK TO MARKET ACCOUNTING

Schuetze argues that the solution to the financial reporting problem does not lie
in improved corporate governance measures alone. He argues that the current
fixation on strengthening corporate governance arrangements, including enhancing
the independence of auditors—as desirable as those arrangements might be—will
not fix the problem. Focusing on the independence of auditors from the
management of their clients, while ignoring the substantial dependence of auditors
upon management for the reported accounting numbers, is to look in the wrong
direction for a solution to the corporate financial accounting and reporting
dilemma. The fundamental problem, argues Schuetze, is a technical accounting
problem. I agree with him.

In his recent testimony before the US Senate Committee on Banking, Housing
and Urban Affairs, Schuetze (2002: 2–3) demonstrates that:

Under our current financial reporting rules promulgated by the Financial
Accounting Standards Board, management of the reporting corporation
controls and determines the amounts reported in the financial statements for
most assets. …The external auditor cannot require that the reported amount
of an asset be written down to its estimated selling price; the external auditor
cannot even require the corporation to determine the estimated selling price of
the asset and disclose that price in its financial statements. So, when it comes
time to sell assets to pay debts, there often are surprise losses that investors see
for the first time. …And under the FASB’s definition of an asset, corporations
report as assets things that have no market price whatsoever; examples are
goodwill, direct response advertising costs, deferred income taxes, future tax
benefits of operating loss carried forward, costs of raising debt capital, and
interest costs for debt said to relate to acquisitions of fixed assets. I call these
non-real assets. Today’s corporate balance sheets are laden with these non-real
assets; this is the kind of stuff that allows stock prices to soar when in fact the
corporate balance sheet is bloated with hot air. Of course, when it comes time
to pay bills or make contributions to employees’ pension funds, this stuff is
worthless. The same goes for liabilities. Corporate management determines the
reported amount of liabilities for such things as warranties, guarantees,
commitments, environmental remediation, and restructurings. Again, this is as
per the FASB’s accounting rules. The upshot is that earnings management
abounds.

With his characteristic ability to get to the nub of a problem, Schuetze goes on in that
testimony to describe the financial reporting dilemma in the following terms:

I liken our current accounting system to bridges built from timber, which
bridges keep collapsing under the weight of eighteen-wheelers. The public
demands that expert consulting engineers be called in to oversee the building
of replacement bridges. But the replacement timber bridges keep collapsing
under the weight of eighteen-wheelers. More expert consulting engineers will

WALTER P.SCHUETZE: ACCOUNTING REFORMER 5

not make the timber bridges any stronger. What needs to be done to fix the
problem is to build bridges with concrete and steel. The same goes with
accounting. In the 1970s, after the surprise collapse of Penn Central, the
auditing profession instituted peer reviews—where one auditing firm reviews
the work and quality controls of another auditing firm. In the 1970s, auditing
firms also instituted concurring partner reviews, where a second audit partner
within the public accounting firm looks over the shoulder of the engagement
audit partner responsible for the audit. These procedures have been
ineffectual as shown by the dozens of Enrons, Waste Managements, Sunbeams,
MicroStrategies, Cendants, and Livents that have occurred since then.
Coincidentally, the Financial Accounting Standards Board also came on the
scene in the 1970s; it was going to write accounting standards that would
bring forth financial statements based on concepts. What happened was that
the FASB wrote a mountain of rules that produce financial statements that
nobody understands and that can be and are gamed by corporate
management. What all of that amounted to was continuing to build timber
bridges that keep collapsing under the weight of eighteen-wheelers. We need
to stop building timber bridges. We need to build concrete and steel bridges.
We need to mark to market all assets and liabilities.

“True north” in financial accounting and reporting

Schuetze is the world’s leading practitioner exponent of mark-to-market accounting
He stands with the world’s leading intellectual exponents of mark-to-market
accounting—Raymond J.Chambers and Robert R.Sterling—and with this writer in
explaining the significant benefits of mark-to-market accounting for auditing and
auditors, and for corporate governance.

Chambers’ theory of Continuously Contemporary Accounting (CoCoA) is
comprehensively set forth in Chambers (1966, 1991) and in several other works (see
Chambers and Dean 1986, 2000). As a theory, CoCoA associates financial
information with financial decision making and market action. Sterling’s major
theoretical treatise on exit price accounting was published in 1970, and the scientific
foundations on which this is based in 1979. By applying the theory of measurement
to accounting and to the determination of enterprise income, Sterling demonstrates
how marking to market all assets and liabilities yields financial information that is
relevant to all financial choices (see many of his other published works in Lee and
Wolnizer 1997). That mark-to-market accounting would transform auditing into a
rigorous process of quality assurance and elevate the notion of independence in
auditing to include the independence of audit evidence, testing and judgment is
demonstrated in Wolnizer (1987).3

Unlike Chambers and Sterling, Schuetze is not concerned with establishing
rigorous theoretical foundations for the measurement of wealth and income. Nor is
he concerned with the theoretical foundations of auditing as a process of
independent verification. Rather, he is fundamentally concerned with the definition

6 MARK TO MARKET ACCOUNTING

and financial quantification of assets and liabilities—with an accounting that works
in the sense of informing the financial decisions of investors and creditors.
However, his formulation of mark-to-market accounting, which he calls “true north,”
is entirely consistent with the drift of the theoretical arguments of Chambers (1966),
Sterling (1970) and Wolnizer (1987). The most comprehensive descriptions of
“true north” are found in Schuetze (2001a; 2001b).

After examining the FASB’s definition of an asset as a probable future economic
benefit—“a high-order abstraction”—he said:

I think we should account for real things such as trucks, not abstract future
economic benefits. I suggest that we adopt a different definition of an asset. A
simple one. …I suggest that we adopt the following definition: cash,
contractual claims to cash, things that can be exchanged for cash, and
derivative contracts having a positive value to the holder thereof.

Schuetze 2001a: 15.

Like Chambers and Sterling, Schuetze defines an asset in terms of exchangeability
for cash. He argues that assets should be valued at fair value, which he defines as
follows:

The estimated amount of cash the asset would fetch in an immediate sale
whether or not under duress, without recourse or guarantees, less the
estimated amount of cash that would have to be paid out to accomplish the sale.
This suggested definition is clear and permits no judgments about the state of
the market or the willingness of the seller to sell at prices being offered or bid
by potential buyers.

ibid.: 20.

He argues that his definition of an asset

would vastly simplify the practice of accounting. Vastly simplify financial
accounting and reporting. I believe that it would appeal to investors,
creditors, and other users of financial statements. I think the results of
applying my definition would appeal to ordinary men and women who walk
up and down Main Street in the USA, and those who walk up and down
Main Street in other countries as well. They would understand the result. My
sister would understand the result. I think that ordinary people who are not
accountants think that when they see an asset on a balance sheet that the asset
is something real, and that the dollar amount associated with the asset
represents value, that is, that the asset can be exchanged for cash for
approximately the dollar amount at which the asset is represented in the
balance sheet.

ibid.: 16.

WALTER P.SCHUETZE: ACCOUNTING REFORMER 7

Turning to liabilities, he said:

The FASB’s definition of a liability [as probable future sacrifices of economic
benefits] is as infirm as its definition of an asset. …I suggest we define
liabilities by reference to future cash outflows required by negotiable
instruments, by contracts, by law or regulation, by court-entered judgments
or agreements with claimants, and derivative contracts having a negative value.

ibid.: 18.

He argues that liabilities should also be valued at fair value, which he defines as
follows: “The least amount of cash that the counterparty would accept in an
immediate and complete liquidation of his/her/its claim against the reporting
enterprise” (ibid.: 20).

Schuetze (ibid.: 20–4) elucidates twelve benefits of adopting the “true north”
formulation of mark-to-market accounting, the most important being:

1 that financial statements in which all assets and liabilities are marked to market
would be intelligible and transparent to all users of financial statements;

2 that the information contained in financial statements would be reliably
verifiable by recourse to commercial evidence that can be independently
corroborated;

3 that opportunities for earnings management and fraud in audited financial
statements would be significantly reduced; and

4 that the currently complex institutional and political accounting standard-
setting apparatus and arrangements would be replaced with a single agency
charged with responsibility for providing guidance on, and refining the
measurement techniques for, estimating market prices.

Schuetze acknowledges that the greatest challenge to implementing mark-to-market
accounting is “estimating cash selling prices for assets for which there is no ready
market” (ibid.: 24). He believes that the provision of guidance on that matter should
be the principal role of the FASB. While acknowledging that “developing that
guidance no doubt would give rise to debates about how to estimate those prices…
that debate would, however, be about something that would be important and
relevant for making investment and credit decisions” (ibid.: 25). Much of the
opposition to the market selling price accounting proposals of Chambers and
Sterling focused on the feasibility of obtaining market price data (McDonald 1968:
38). These unfounded criticisms prompted inquiries about the availability of market
price data for several classes of commodities in different countries.4 All of those
studies demonstrated that up-to-date price data were readily available at little cost
While no generalizations can be made from those studies, they do suggest that the
practical problems associated with the implementation of mark-to-market
accounting may not be as significant as is sometimes surmised. Furthermore, the
recent professional moves to adopt “fair value” accounting in limited settings such

8 MARK TO MARKET ACCOUNTING

as accounting for financial instruments is another confirmation of the availability of
market price data,

In determining what information is understandable by “ordinary folk” and what
information is most relevant for making investment and credit decisions, Walter
Schuetze said:

Schuetze 2001a: 5.

Hence the subtitle of his article in Abacus (ibid.): “Accounting that my sister would
understand.” It is a style of accounting that hundreds of respondents to
comprehensive surveys administered in Australia, Canada and Singapore also
understand.5 It is a style of accounting that investors, creditors, regulators, corporate
managers and corporate directors—as well as accountants—will understand. A style
of accounting that will provide factual, up-to-date, decisionrelevant and reliably
verified financial information to, and be transparent in, capital markets. According
to Schuetze, mark-to-market accounting is “intuitively” obvious. It is not rocket
science. It is readily understandable by all who have experience of normal
commercial activity, of buying and selling, of lending and borrowing—of financial
and market action.

In his testimony before the US Senate Committee on Banking, Housing and Urban
Affairs (2002), Schuetze presented a pithy summary of “true north.” In addressing
the questions “how do we stop earnings management,” which entails taking
“control of the reported [accounting] numbers out of the hands of corporate
management,” he said:

We do it by requiring that the reported numbers for assets and liabilities… be
based on estimated current market prices—current cash selling prices for
assets and current cash settlement prices for liabilities. And by requiring that
those prices come from, or be corroborated by, competent, qualified, expert
persons or entities that are not affiliated with, and do not have economic ties
to, the reporting corporate entity. And by requiring that the names of the

WALTER P.SCHUETZE: ACCOUNTING REFORMER 9

persons or entities furnishing those prices, and the consents to use their
names, be included in the annual reports and quarterly reports of the
reporting corporate entity so that investors can see who furnished the prices.

Schuetze 2002: 3.

To my knowledge this is the most profoundly reformist proposal in respect of
financial accounting and reporting, and corporate auditing, to come from the pen
of an accounting practitioner. It is informed by a highly expert understanding of an
accounting that has been shown repeatedly in corporate failures and litigated cases
to be technically defective and to yield financial information that lacks
intelligibility, transparency and relevance for financial decision making —
conventional historical cost accounting.6 It is also informed by extensive, high-level
experience that suggests that market selling price accounting can be implemented in
practice.

Schuetze’s “true north” proposals are consistent with and are based on rigorous
established—and to my knowledge largely unrefuted—theoretical foundations: the
association between financial information and market action (Chambers 1966,
1991); the application of measurement theory to accounting (Sterling 1970, 1979);
and auditing as a process of independent authentication and quality control
(Wolnizer 1987).

Mark-to-market accounting: historical and contemporary
perspectives

It may be thought that the idea of market selling price accounting is of relatively
recent origin—perhaps since the mid-twentieth century. It is not. While the ground-
breaking and major theoretical treatises on market selling price accounting by
Chambers and Sterling date from the 1950s and 1960s, respec tively, the notion that
assets are legally owned objects and rights that are exchangeable for cash—and that
should be valued at current market selling prices—predates the UK Joint Stock
Companies Act of 1844. This is the Act from which the occurrence of such phrases
as “true and correct” and “true and fair” as statutory specifications of the quality of
financial statements is generally dated.

The meaning of “true and correct” or “true and fair” as the statutory quality
standard for financial reporting has never been clarified by statute, case law or
statements promulgated by professional accounting bodies or regulatory agencies.
Consequently, it has been a matter of debate over the last thirty-five years or so.
However, largely absent from that debate has been a consideration of the subjects of
which a “true and fair view” is to be provided: namely, the dated financial position
and financial performance of firms. Lacking specification of those subjects, the
debate has been largely fruitless—notwithstanding the overriding rule (of truth and
fairness in financial reporting) and the apparently critical importance of the
meaning of the phrase (see Chambers and Wolnizer 1990).

10 MARK TO MARKET ACCOUNTING

Being curious about the origins of the description “true and correct” or “true and
fair,” Chambers and Wolnizer (1991) searched statutory references, contractual
references and bookkeeping manuals dated prior to 1844 for any indications of the
meaning and intention of the statutory quality standard for financial reporting. The
material presented in that study was considered by the authors to have established a
prima facie case for two propositions:

(a) that “true and correct” and “true and fair” and like terms are simply
expressions in the vernacular of the intent that financial accounts and
summaries shall be false to the dated financial facts of companies in no
material respect; (b) that in respect of property and other assets, the use of
market selling prices…and not cost prices would give the required view of a
dated state of affairs and dated profits or results.

Chambers and Wolnizer 1991: 211.

Twenty-four partnership agreements (1714–1829) and seventy deeds of settlement
(1827–43) were examined in that inquiry. The lengths to which a deed of settlement
might go are indicated in the 1827 deed of the Huddersfield Banking Company.
That deed stipulated that the directors:

shall cause to be provided and kept…all necessary and proper books of
account, wherein shall be entered in a fair, regular and plain method, an
account of all receipts, payments, transactions and dealings…and of all
profits, gains and losses…[and shall twice yearly] take and make up a fair,
accurate, and just statement and account of the stock and capital…so that the
real state of the affairs of the company may in such statement plainly appear.

ibid.: 203.

The deed goes on to stipulate how the property (or assets) of the bank were to be
valued:

in each such stock-taking, reference shall be had to the then value of the
funded and all other property of the company which shall be estimated, not at
the cost, but at the then selling price thereof; so that the real state of the
affairs of the company may in such statement plainly appear.

ibid.: 208.

Of the fifty-five bank deeds examined that gave a general valuation rule, twenty-six
were of the style “not at the cost but at the then selling price…so that the real state
of affairs may plainly appear” twenty-nine were of the style “at the then fair
estimated value…for fully manifesting the state of affairs” (ibid.: 208).

Characteristic of the wording of the partnership agreements and deeds of
settlement was the use of two or more words to describe the financial reporting
required: for example, “true state or representation,” “well and truly,” “fairly and

WALTER P.SCHUETZE: ACCOUNTING REFORMER 11

regularly,” “fairly and impartially,” “true and fair,” “just true plain perfect and
particular.” These phrases forcefully express the idea that the financial affairs of an
entity were to be conducted and reported with the utmost circumspection.

In his R.J.Chambers Research Lecture (2001b: 3), Walter Schuetze provides the
following interesting insight into the introduction of mark-to-market accounting in
the USA:

Few people know that to the extent that we have mark-to-market accounting
today, the credit for that belongs to the Securities and Exchange Commission,
and primarily to Chairman Breeden. Incidentally, none of those
commissioners in 1990 was an accountant. …When the SEC endorsed mark
to market on bonds in 1990, the banking, thrift, and insurance companies
community had to be dragged, kicking and screaming, into the world of
relevant, mark-to-market accounting. In a sense, the FASB was also dragged
along by the SEC because none of the FASB’s constituencies was in favour of
mark to market, and the FASB itself was not out in front leading the charge
for mark to market. But, come around it did, and now the FASB is moving
forward on mark to market for all financial assets and liabilities.

Most recently, the Australian government—under the auspices of the
Commonwealth Treasury—has called for fundamental accounting reform and the
introduction of mark-to-market accounting. I believe this to be a world first. In
1997, the Australian government introduced the Corporate Law Economic Reform
Program (CLERP). Its first reform proposal is contained in a paper titled
“Accounting Standards: Building International Opportunities for Australian
Business” (hereafter CLERP 1, 1997). While CLERP 1 advocates the international
harmonization of accounting standards (and CLERP 9, 2002, requires Australian
companies to report in accordance with IASB standards from 2005), the burgeoning
literature on CLERP is overwhelmingly concerned with the harmonization issue
while inadvertently neglecting, or choosing to remain silent about, the more far-
reaching and significant reform agenda of mark-to-market accounting.

CLERP 1 (1997: 1) states that “It should be made clear in legislation that
accounting standards should be interpreted from a commercial perspective to
promote compliance by preparers of accounts, not only with the black letter of the
standard, but also its overall purpose.” CLERP 1 articulates the meaning of
“commercial perspective” in the following words: “By a commercial perspective, it is
intended that more weight should be given to the objectives of the standards and
what is generally considered in the relevant market to be good commercial practice”
(ibid.: 15). And that purpose? “The basic purpose of accounting standards is to
facilitate the provision of financial information about entities to enable investors,
analysts, creditors and the entities themselves to make informed decisions about the
allocation of resources. Accounting standards are essentially about disclosure and, in
many respects, are at the heart of market efficiency” (ibid.: 13).

12 MARK TO MARKET ACCOUNTING

The consistency between CLERP 1 and what Schuetze describes as a “capital
markets approach” to accounting standard setting is clear:

Accounting standards that result in the provision of accurate and comparable
information about the true financial performance and position of business
entities promote investor confidence and market integrity, thereby ultimately
reducing the costs of capital throughout the economy. Public confidence in
the integrity of the financial reporting framework is central to maintaining
and expanding a sophisticated domestic capital market.

ibid.: 13–14.

Having regard to that objective of promulgating accounting standards, CLERP 1
states:

it should be specifically stated, either in the charter of the standard setter or in
the legislation under which it is established, that in designing accounting
standards, the standard setter should seek to ensure that compliance with
accounting standards leads to the production of relevant, reliable, neutral and
comparable financial information for users of financial statements.

ibid.: 14.

While advocating that Australian companies adopt IASB standards in the
“immediate future,” CLERP 1 does not contemplate that conventionally prepared
financial statements possess the attributes of relevance, reliability, neutrality and
comparability:

In a world of often rapidly changing asset and liability values…fluctuating
interest rates and other market developments, measurement based on
historical cost can be largely meaningless for the purpose of assessing the
financial standing or solvency of an entity.

In view of the need for informed capital markets, there is a need to move
away from the current historical cost accounting framework and to introduce
a disclosure regime based on market value and risk accounting.

ibid.: 59.

Furthermore, “Australia should be promoting moves internationally to introduce
market value accounting and working cooperatively to address fundamental issues
such as measurement” (ibid.: 59).

By market value accounting—or mark-to-market accounting—CLERP 1 means
the following:

• in the case of an asset—the amount which could be expected to be received
from the disposal of the asset in an orderly market; and

WALTER P.SCHUETZE: ACCOUNTING REFORMER 13

• in the case of a liability—the amount which could be expected to be paid
to extinguish the liability in an orderly market.

ibid.: 60.

While Schuetze’s “true north” proposal makes no presumptions about the state of
markets and hence removes any ambiguity about whether a market is orderly or
otherwise, the directive force of mark-to-market accounting in CLERP 1 is
fundamentally consistent with “true north.” (Like Schuetze, Sterling insists on cash
selling—or exit—prices at the date of the balance sheet. Like CLERP 1, Chambers
contemplates market selling prices at the date of the balance sheet “in the ordinary
course of business.”)

CLERP 1 acknowledges that “While market value principles have been included
in a number of Australian accounting standards (for example, in accounting for the
general insurance industry), the method is not favoured by the business
community” (ibid.: 60). Notwithstanding this opposition, CLERP 1 advocates
mark-to-market accounting because it “would enable the markets to operate more
efficiently through a reliance on enhanced transparency from institutions and
corporations in relation to their operations. In particular, market value accounting
would provide a more informative means of financial reporting for investors, market
participants and regulators” (ibid.: 60). According to CLERP 1, the advantages of
mark-to-market accounting are that it provides greater transparency, better reflects
risk management practices and obviates the need for ledger accounting (ibid.: 60).

So we have solidly established and unrefuted theoretical foundations for mark-to-
market accounting, evidence that the basic ideas of mark-to-market accounting have
a rich history, evidence of the ready availability of market price data for a variety of
commodity classes and evidence that at least one distinguished accounting
practitioner and the Australian government (at least in CLERP 1) believe that mark-
to-market accounting can and should be implemented.

The cost of implementing mark-to-market accounting

With earnings management rampant, and with a widely acknowledged crisis of
confidence in the integrity and reliability of financial reporting and auditing, it is
reasonable to ask “what would it cost to implement mark-to-market accounting?”
There is no definitive answer to that question. However, it is a question that was
raised and addressed by Schuetze in his testimony before the US Senate Committee
on Banking, Housing and Urban Affairs.

Returning to his analogy of wooden versus concrete and steel bridges, he asked:

Can we afford to build concrete and steel bridges? My response is that we
cannot afford not to build concrete and steel bridges. How much of the cost
of the S&L bail-out was attributable to faulty accounting; the amount is
unknowable but no doubt was huge. How much does an Enron or Cendant or

14 MARK TO MARKET ACCOUNTING

Waste Management or MicroStrategy or Sunbeam cost? The answer for
investors is billions, and that does not count the human anguish when
working employees lose their jobs, their 401k assets, and their medical
insurance, and retired employees lose their cash retirement benefits and
medical insurance. By some estimates, Enron alone cost $60–70 billion in
terms of market capitalization that disappeared in just a few months. Waste
Management, Sunbeam, Cendant, Livent, MicroStrategy, and the others also
cost billions in terms of market capitalization that disappeared when their
earnings management games were exposed. And, these costs do not include the
immeasurable cost of lost confidence by investors in financial reports and the
consequent negative effect on the cost of capital and market efficiency.

By my estimate, annual external audit fees in the United States for our 16,
000 public companies, 7,000 mutual funds, and 7,000 broker/dealers total
about $12 billion. Let’s say that $4 billion is attributable to mutual funds and
broker/dealers. (Incidentally, mutual funds and broker/dealers already mark to
market their assets every day at the close of business, and we have very few
problems with fraudulent financial statements being issued by those entities.
Mark to market works and is effective.) That leaves $8 billion attributable to
the 16,000 public companies. Assume that the $8 billion would be doubled
or even tripled if the 16,000 public companies had to get competent, outside
valuation experts…to determine the estimated cash market prices of their
assets and liabilities. We are then looking at an additional annual cost of $16–
24 billion. If we prevented just one Enron per year by requiring mark-to-
market accounting, we would easily pay for that additional cost. And, when
considered in relation to the total market capitalization of the US corporate
stock and bond markets of more than $20 trillion, $16–24 billion is indeed a
small price to pay.

Schuetze 2002: 5.

A small price indeed for factually informative and reliably audited financial reports,
and a solid foundation for corporate governance.

Who should mandate mark-to-market accounting?

Both Chambers and Schuetze have addressed that question. In his R.J. Chambers
Research Lecture (2001b: 11), Schuetze said:

I have been in this business since August 1,1957. I think that I have seen
every side and dimension of this [earnings management] problem. …The SEC
must make deep and fundamental changes to the [accounting] system. Unless
and until the SEC requires that assets be reported at estimated selling prices,
which of course means that only things that have a market price could be
represented as assets, nothing will change. Unless and until the SEC requires
that liabilities be reported at estimated settlement prices, nothing will change.

WALTER P.SCHUETZE: ACCOUNTING REFORMER 15

Unless and until the SEC requires that…external auditors get evidence about
those selling and settlement prices from persons or entities outside the
reporting enterprise, nothing will change.

Again, in his testimony before the US Senate Committee on Banking, Housing and
Urban Affairs (2002: 5), Schuetze stated:

I recommend that there be a sense of the Congress resolution that corporate
balance sheets must present the reporting corporation’s true
economic financial condition through mark-to-market accounting for the
corporation’s assets and liabilities. I recommend that Congress leave
implementation to the SEC, much the way it is done today by the SEC for
broker/dealers and mutual funds.

Like Schuetze, Chambers anticipated that the introduction of mark-to-market
accounting will require legislation. As chairman of the Accounting Standards Review
Committee appointed by the New South Wales Government (1978), he suggested
that the following two sentences in the Corporations Act would be sufficient:

No balance sheet shall be deemed or declared to give a true and fair view of the
state of affairs of a company unless the amounts shown for the several assets,
other than cash and amounts receivable, are the best available approximations
to the net selling prices in the ordinary course of business of those assets in
their state and condition as at the date of the balance sheet.

No profit and loss account shall be deemed or declared to give a true and
fair view of the profit or loss of a company unless that profit or loss is so
calculated as to include the effects during the year of changes in the net selling
prices of assets and of changes in the general purchasing power of the unit of
account.7

In Australia, the CLERP would be a convenient vehicle for introducing such a
requirement into the Corporations Law.

A concluding comment

I am delighted and honored to be a friend and colleague of Walter Schuetze. We
first met in Washington in 1998 while he was chief accountant to the Enforcement
Division of the SEC. Since then, we have enjoyed countless conversations about
accounting and auditing in Washington, Houston, San Antonio and Sydney. We
maintain a regular dialogue as the unwelcome financial and professional
consequences of the spread of Enronitis continue unabated and, from our
observation of the pronouncements of accounting standard-setting bodies, without a
cure in prospect. My admiration of his reformist accounting ideas and professional

16 MARK TO MARKET ACCOUNTING

ideals has grown increasingly as I have read and reread his articles, speeches and
letters in the course of preparing this volume.

In compiling this anthology I acknowledge my debt to Walter. Over the last five
years, I have learned more about the intricacies of accounting and auditing practices
and standards than I could ever have imagined. And I have been fascinated to learn
about the world of accounting practice, accounting standard setting and corporate
regulation. Importantly, he has greatly stimulated my thinking about the practical
benefits and possibility of implementing mark-to-market accounting.

Having had the personal pleasure and intellectual privilege of completing my PhD
under Ray Chambers’ rigorous supervision, and of undertaking my post-doctoral
studies under Bob Sterling’s stimulating mentoring, it has been my very good
fortune to learn about the practicalities of implementing mark-to-market
accounting from Walter Schuetze. While the theoretical case for mark-to-market
accounting, established by Chambers and Sterling, is compelling and substantially
unchallenged, Walter Schuetze is the first practitioner to argue the case on practical
grounds. In the light of the most recent experiences of Enronitis, the cases put by
Chambers, Schuetze and Sterling for mark-to-market accounting seem unassailable.
They merit the most serious and urgent consideration by national and international
accounting and auditing standard setters and corporate regulators.

I hope that all who read this book will benefit as much as I have from the
extensive experience, penetrating insights and informed understanding of one of the
most eminent accountants in the world in relation to financial accounting and
reporting and corporate auditing: Walter P.Schuetze, accounting reformer.

Notes

1 The US General Accounting Office found 919 retrospective restatements of financial
statements for accounting irregularities by 845 public companies between January
1997 and June 2002 (see GAO-03–138, “Financial statement restatements-trends,
market impacts, regulatory responses, and remaining challenges,” 4 October 2002).

2 For a comprehensive analysis of several of those corporate failures, covering their
accounting, ethical and regulatory dimensions, see Clarke et al. 2003.

3 See also Chambers 1973; Lee 1993, Sterling 1968, 1970; Wolnizer 1978, 1995.
4 McDonald 1968; Foster 1969; McKeown 1971; Gray 1975; Wolnizer 1977, 1983;

see also Dean and Wells 1984.
5 Chambers and Falk 1985; Chambers and Clarke 1986; Chambers et al. 1987.
6 See, for example, Chambers 1973; Clarke et al. 2003; Stamp et al. 1980; Sykes 1994.
7 See Chambers, 1973:219; Chambers et al. 1978:97; Chambers and Wolnizer 1990:

366.

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WALTER P.SCHUETZE: ACCOUNTING REFORMER 17

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Vancouver: Canadian Certified General Accountants Research Foundation.
Chambers, R.J., Ma, R., Hopkins, R. and Kasiraja, N. (1987) Financial Information and

Decision Making: A Singapore Survey, Singapore: Singapore Institute of Management and
University of Sydney Accounting Research Centre.

Chambers, R.J., Ramanathan, T.S. and Rappaport, H.H. (1978) Company Accounting
Standards, report of Accounting Standards Review Committee to NSW Attorney
General, Sydney: NSW Government Printer.

Chambers, R.J. and Wolnizer, P.W. (1990) “A true and fair view of financial position,”
Company and Securities Law Journal 8, 354–68; reprinted in Economia Aziendale, X:
183–203 and also in R.H.Parker, P.W.Wolnizer and G.W.Nobes (eds) (1995) Readings
in True and Fair, New York: Garland, 153–68.

Chambers, R.J. and Wolnizer, P.W. (1991) “A true and fair view of position and results: the
historical background,” Accounting, Business and Financial History 1, 197–213; reprinted
in G.G. Kaufman (ed.), Research in Financial Services: Private and Public Policy, 5, 1–17
and also in R.H.Parker, P.W.Wolnizer and C.W.Nobes (eds) (1995) Readings in True
and Fair, New York: Garland, 5–21.

Clarke, F.L., Dean, G.W. and Oliver, K.G. (2003) Corporate Collapse: Regulatory, Accounting
and Ethical Failure, 2nd (revised) edn, Melbourne: Cambridge University Press.

Commonwealth of Australia (1997) “Accounting Standards: Building International
Opportunities for Australian Business,” Corporate Law Economic Reform Program:
Proposals for Reform: Paper No. 1, Canberra: Treasury.

Commonwealth of Australia, (2002) “Corporate disclosure—strengthening the financial
reporting framework,” Corporate Law Economic Reform Program: Proposals for Reform:
Paper No. 9, Canberra: Treasury.

Dean, G.W. and Wells, M.C. (eds) (1984) The Case for Continuously Contemporary
Accounting, New York: Garland.

Foster, G.J. (1969) “Mining inventories in a current price accounting system,” Abacus 5, 99–
118; reprinted in G.W.Dean and M.C.Wells (eds) (1984) The Case for Continuously
Contemporary Accounting New York: Garland, 367–86.

Gray, S.J. (1975) “Price changes and company profits in the securities market,” Abacus 11,
71–85; reprinted in G.W.Dean and M.C.Wells (eds) (1984) The Case for Continuously
Contemporary Accounting, New York: Garland, 405–19.

Lee, T.A. (1993) Corporate Audit Theory, London: Chapman & Hall.
Lee, T.A. and Wolnizer, P.W. (eds) (1997) The Quest for a Science of Accounting: An

Anthology of the Research of Robert R.Sterling, New York: Garland.
McDonald, D.L. (1968) “A test application of the feasibility of market based measures in

accounting,” Journal of Accounting Research 6, 38–49; reprinted in G.W.Dean and M.C.

18 MARK TO MARKET ACCOUNTING

Wells (eds) (1984) The Case for Continuously Contemporary Accounting, New York:
Garland, 355–66.

McKeown, J.C. (1971) “An empirical test of a model proposed by Chambers,” Accounting
Review XLVI, 12–29; reprinted in G.W.Dean and M.C.Wells (eds) (1984) The Case for
Continuously Contemporary Accounting, New York: Garland, 387–404.

Schuetze, W.P. (2001a) “What are assets and liabilities? Where is true north? (Accounting
that my sister would understand),” Abacus 37, 1–25.

Schuetze, W.P. (2001b) “A memo to national and international accounting and auditing
standard setters and securities regulators”, R.J. Chambers Memorial Research Lecture,
Sydney: Accounting Foundation within the University of Sydney.

Schuetze, W.P. (2002) prepared statement by Mr Walter P.Schuetze, chief accountant,
Securities and Exchange Commission 1992–5, hearing on “Accounting and Investor
Protection Issues Raised by Enron and Other Public Companies: Oversight of
the Accounting Profession, Audit Quality and Independence, and Formulation of
Accounting Principles,” US Senate Committee on Banking, Housing, and Urban
AfFairs, http://banking.senate.gov/02_02hrg/022602/schuetze.htm.

Stamp, E., Dean, G.W and Wolnizer, P.W. (eds) (1980) Notable Financial Causes Célèbres,
New York: Arno Press.

Sterling, R.R. (1968) “A glimpse of the forest,” The Accountant’s Journal, November: 589–
94; reprinted in T.A.Lee and P.W.Wolnizer (eds) (1997) The Quest for a Science of
Accounting An Anthology of the Research of Robert R. Sterling, New York: Garland, 375–
80.

Sterling, R.R. (1970) Theory of the Measurement of Enterprise Income, Lawrence: University
Press of Kansas.

Sterling, R.R. (1979) Toward a Science of Accounting, Houston: Scholars Book Co.
Sykes, T. (1994) The Bold Riders: Behind Australia’s Corporate Collapses, Sydney: Allen &

Unwin.
Wolnizer, P.W. (1977) “Primary production inventories under current value accounting,”

Accounting and Business Research 28, 303–10; reprinted in G.W.Dean and M.C.Wells
(eds) (1984) The Case for Continuously Contemporary Accounting, New York: Garland,
421–8.

Wolnizer, P.W. (1978) “Independence in auditing: an incomplete notion,” Abacus 14, 31–
52.

Wolnizer, P.W. (1983) “Market prices v. cost indexation in accounting for steel inventories,”
Abacus 19, 171–88.

Wolnizer, P.W. (1987) Auditing as Independent Authentication, Sydney: Sydney University
Press.

Wolnizer, P.W. (1995) “Are audit committees red herrings?” Abacus 31, 45–66.

WALTER P.SCHUETZE: ACCOUNTING REFORMER 19

2
Autobiography

Walter P.Schuetze

I was born on 2 August 1932 in Comfort, Texas, USA. I was raised on a farm
located in south-central Texas in Kerr County between Comfort and Center Point,
Texas, about fifty miles northwest of San Antonio and about one hundred miles
west and slightly south of Austin, the capital of Texas.

Grades one through seven from September 1938 through May 1945 were in a one-
room schoolhouse in Kerr County on the banks of the Guadalupe River. (A second
room was added in about 1943, where we ate our cold lunches brought from
home.) It was called the Union Valley School. There were three children in my class
for all seven years, Lorraine Boerner, Leroy Pressler, and me. I don’t recall exactly,
but at most there were about twenty-five children in the Union Valley School. From
1938 to 1942, our teacher was Bodo Burrow. In 1942, he entered the US Navy on
account of World War II. He was succeeded by an eighteen-year-old woman, Helen
Spenrath, who had just graduated from high school. She taught all twenty-five of us
reading, writing, arithmetic, geography, and history—in one room. We all learned
together. She was wonderful.

I then went to Center Point High School for grades nine through twelve. (No
grade eight.) On graduation in 1949, I was the class valedictorian. It was there that
two teachers—Grace Wallis and Frank Gilliland—took me under their wings,
mentoring me for three years. They took me with them wherever they went—to
bull fights in Mexico, to the opera in San Antonio, and to open-air symphony
concerts in Boulder, Colorado. They took me with them to college at Stephen
F.Austin State College in Nacogdoches in east Texas in the summer of 1949, where
they took postgraduate courses and I started my college learning. I cannot express
how much I enjoyed their company and how much I am indebted to them for
opening my eyes to the world around me.

I moved from Stephen F.Austin to the University of Texas at Austin in the fall of
1950. My major was in English language, and my minor was in foreign languages. I
was going to be an English teacher. I enrolled in a course in Russian language in

1950, because a course in Spanish language, which I wanted to take, was not available.
That course in Russian language changed the course of my life.

In January 1951, the Korean conflict was in full throttle, and I enlisted in the US
Air Force. When the military learned that I knew some Russian, I was shipped off to
the Army Language School in Monterey, California, and I spent six months learning
more Russian. I became a Russian language specialist in the Security Service of the
Air Force. From the summer of 1952 through May 1955, I was stationed in
England and Scotland, where I, and others in the Air Force, monitored the voice
and telegraphic traffic of the Soviet army and air force in East Germany and
Europe. It was in Scotland that I met and married my wife Jean.

While in Scotland, I read an article in a magazine, maybe Time, about
accountants and accounting. Somehow, I was attracted to the idea of being an
accountant. So, after I finished my tour of duty in the Air Force in 1955, I went
back to the University of Texas at Austin and began to study accounting. I liked it I
still do.

My accounting teachers at the university included George Newlove (cost
accounting), Glenn Welsch (advanced accounting), and John White (introductory
accounting In the 1950s, they were leaders in accounting in academia and had all
written textbooks.

I graduated from the university with honors in the summer of 1957. My degree is
a Bachelor of Business Administration. I was and am a member of Beta Alpha Psi
and Beta Gamma Sigma honorary societies.

I need to mention here that but for the GI Bill of Rights, I would not have been
able to finish college as I did not have the money to do so. Pursuant to the GI Bill,
every veteran of World War II and the Korean War was entitled to receive a stipend
to attend college. That stipend, about $89 a month as I recall, allowed me to attend
college and get my degree. I am grateful to the American public for that stipend. It
was a godsend.

On 1 August 1957, I started work as a junior staff accountant with a small public
accounting firm in San Antonio, Eaton & Huddle. Although I had received offers
of employment from all of the companies and firms that I had interviews with—two
Fortune 500 companies, three of the then big eight accounting firms, and Eaton &
Huddle—I decided to join the last of these. I had been interviewed on campus by
Thomas L.Holton of Eaton & Huddle. After my visit to the firm’s offices and
meeting the people there, Tom Holton made me an offer; I decided to join Eaton &
Huddle because I liked the cut of Tom Holton’s jib and because I thought that I
would get more varied experience in a small firm and at the same time be closer to
the partners than in a large firm. Eaton & Huddle had three senior partners, led by
Marquis Eaton, who at the time was president of the American Institute of Certified
Public Accountants. The firm had four junior partners, including Tom Holton, and
about thirty staff. Marquis Eaton died in the spring of 1958. On 1 July 1958, Eaton
& Huddle merged with Peat, Marwick, Mitchell & Co., now KPMG LLP. Tom
Holton would later be elected chairman of Peat Marwick.

I received my public accounting certificate from the state of Texas in 1959.

MARK TO MARKET ACCOUNTING 21

My first six years in public accounting were in San Antonio. Audit and tax clients
were primarily small oil and gas exploration and production companies, oil and gas
drilling companies, banks, savings and loan associations, and insurance companies.
For the most part these clients were not public companies, although a few were.
Financial institutions were just beginning to have audits of their financial
statements performed by independent public accountants (in addition to
examinations by regulators such as the banking authorities). Peat Marwick was to the
fore in auditing the financial statements of financial institutions. I participated in
many of those audits, first as a staff accountant and then at progressively higher
levels. Peat Marwick performed the first external audit of the financial statements of
Chase Manhattan Bank in either 1959 or 1960, and I went from San Antonio to
New York to participate in that audit. I spent about four weeks working on that audit.
What a wonderful experience.

In the 1950s and 1960s, many small and medium-sized companies were becoming
public companies so as to raise money, grow, and compete. The public accounting
profession was growing by leaps and bounds. So was Peat Marwick. To deal with
this growing number of public company clients, among them many financial
institutions, Peat Marwick created its Department of Professional Practice in New
York, known as DPP. The department started with two partners, John Peoples and
George Shepherd, one career manager and three newly minted managers, one from
Philadelphia, one from Los Angeles, and me from San Antonio. (At the time of
writing in 2002, DPP had a hundred partners and senior managers.) John Peoples
was the firm’s representative on the AICPA’s Accounting Principles Board and had
been the firm’s representative on the AICPA’s Committee on Accounting
Procedure, The managers were to spend two years in DPP in New York and then go
back to an operating office. I stayed for seven years.

What DPP did, in those early years, was help partners and managers in practice
offices to deal with accounting and auditing problems (mostly accounting
problems), review clients’ financial statements after their issuance to detect areas for
improvement in future years, review the financial statements of non-clients to
determine best practices, prepare firm bulletins and manuals and disseminate those
to practice offices, and serve as staff to the firm’s committees of senior partners who
dealt with accounting and regulatory matters arising primarily with respect to public
company clients that filed financial statements with the US Securities and Exchange
Commission.

I worked in DPP from the summer of 1963 to the summer of 1970. I was
admitted to the partnership in 1965. I worked with John Peoples and then with
Joseph P. Cummings, who succeeded John Peoples on the Accounting Principles
Board. From 1965 to the summer of 1970, I was Joe Cummings’ technical adviser
and attended meetings of the Accounting Principles Board as an observer. (Joe
Cummings was the second chairman of the International Accounting Standards
Committee in the 1970s after the APB was dissolved.) The APB met for about three
days every other month. I watched as the APB deliberated and wrote Opinions 9
through 17. In fact, I did more than watch. Observers, and there were seven or

22 WALTER P.SCHUETZE: AUTOBIOGRAPHY

eight of us, would, overnight, draft portions of Opinions that the APB had
deliberated that day for the APB to review, redeliberate, and re-vote the next day.
Many times, the APB changed its mind the next day, and we observers went back to
the drafting table to craft new language based on new instructions from the APB.
Fascinating work. “Work” is not the right word; it was, to me, a labor of love. I am
to this day fascinated with writing the words of accounting standards, observing how
financial statements are prepared using those standards, and observing how those
financial statements are then used by investors in making investment decisions.

While in DPP, I prepared, with the help of a number of partners and managers
located in operating offices, the firm’s Accounting and Audit Manual for Savings
and Loan Associations, worked on other technical manuals and bulletins, reviewed
filings by clients with the Securities and Exchange Commission, and assisted
partners in operating offices of the firm in responding to accounting and auditing
matters that arose in practice.

My stay in DPP started in 1963, and in 1970 Joe Cummings insisted that I go
out to an operating office and deal with clients on a day-to-day basis. So, in the
summer of 1970, I transferred to the firm’s Los Angeles office and worked as an audit
engagement partner and SEC reviewing partner. (It was the firm’s policy that all
client registration statements filed with the Securities and Exchange Commission be
reviewed by a designated SEC reviewing partner who was not the audit engagement
partner.) While in Los Angeles, I served as the audit engagement partner to Bourns
Inc., City Investing Company, Max Factor, Motel 6, Southern California Savings
and Loan Association, and Western Airlines.

Late in 1972, I was invited to serve as a member of the newly formed Financial
Accounting Standards Board. In March 1973, the FASB began operations, and I
moved from Los Angeles to Stamford, Connecticut, where the FASB was originally
located. (It is now located in Norwalk, Connecticut.) I served on the FASB until 30
June 1976. My term on the FASB ran for five years, from 1973 through 1978, but I
decided to go back to public practice in 1976.

The early years at the FASB were fascinating. Board members did nitty-gritty,
pick-and-shovel work, drafting discussion memoranda, exposure drafts, and final
statements of financial accounting standards. Board meetings often ran late into the
night. Board members and staff understood why the AICPA’s Committee on
Accounting Procedure and the Accounting Principles Board had not achieved their
desired measure of success, and we very much wanted to prove to the world, and to
ourselves, that we could succeed in setting standards where our predecessors had
not. There was a great sense of camaraderie and a can-do spirit. I signed FASB
Statements of Financial Accounting Standards 1–12 and Interpretations 1–9.
Statements 3, 4, 6, 7, 10, and 11 dealt with very narrow issues and continue in force
today. Statements 1, 8, 9, and 12 have been superseded by subsequent statements.
Statement 2, R&D costs, and Statement 5, loss contingencies, were and are broad in
scope and application and continue in force today.

In those early days of the FASB, we did not have a written conceptual framework
as the FASB has now, We relied on our experiences, judgment, and intuition in

MARK TO MARKET ACCOUNTING 23

writing the early standards that were issued by the FASB. In retrospect, I think that
we were not very successful. FASB Statement 2—expense R&D costs as incurred—
has survived but is under attack by many who would like to see some or all R&D costs
capitalized or who would like to see the value of a company’s R&D represented on
its balance sheet (I like the results of Statement 2 because I think that only things
that can be exchanged for cash may be represented as assets in balance sheets and,
incidentally, that costs can never be assets. The reason given in Statement 2 for
charging to expense all R&D costs as incurred is that the future benefit is uncertain,
not that things that are represented in balance sheets as assets must be exchangeable
and that costs may not be represented as assets.) FASB Statement 8 on foreign
currency translation was faithful to the historical cost notion as to non-monetary
assets, but it lasted only a few years and was replaced by Statement 52. Corporations
would not accept the income-statement results produced by Statement 8, primarily
because cost of inventory was translated at the historical rate instead of the current
rate, which put the effect of exchange rate changes into the period of the sale of the
inventory instead of when the exchange rate changed. Statement 52 makes a pig’s
breakfast of balance sheets, what with (1) domestic non-monetary assets at historical
cost and foreign non-monetary assets at historical cost but translated at the current
exchange rate instead of the exchange rate in existence at the time of the acquisition
of the asset and with (2) deferral of transaction gains and losses on management-
designated economic hedges of net investments in a foreign entity and translation
adjustments.

FASB Statement 5 on loss contingencies (warranties, bad debts, claims against the
corporation by outsiders, and the like) looks and sounds good but does not work in
practice. The two standards in Statement 5—probable that a loss has been incurred
and the amount of loss is reasonably estimable—allow for so much judgment and
leeway that in practice they amount to no standard at all. Witness the manner in which
commercial banks measure their bad debt allowances—almost any amount that they
want. I have told the FASB on numerous occasions that Statement 5 does not work.

The FASB has now had a written conceptual framework for about fifteen years,
but I think that the FASB’s standards, said to be based on that framework, are
producing financial statements that are not very useful in the hands of investors
trying to make investment decisions. I have made several speeches and written
several articles expressing my views about financial statements that are being
produced nowadays as a result of the FASB’s standards; the most recent and most
comprehensive article is entitled “What are assets and liabilities? Where is true
north? (Accounting that my sister would understand),” which appeared in Abacus in
February 2001. Rather than repeat or summarize that article here, I refer the reader
of this piece to that article.

In July 1976, I returned to KPMG’s DPP in New York as a partner in the firm.
(When I left the firm in 1973, I severed all ties with it and had no agreement or
understanding that I would or could return. It just so happened that when I decided
in 1976 to leave the FASB and go back to public practice, the partner in KPMG’s
DPP who was in charge of the Accounting Group function had become ill, and

24 WALTER P.SCHUETZE: AUTOBIOGRAPHY

there was an opening for a person with my background, skills, and experience.) I
served in DPP until January 1992, when I was appointed chief accountant to the
US Securities and Exchange Commission.

In DPP, I was the partner in charge of the Accounting Group and had
responsibility for the preparation and maintenance of the firm’s Accounting Manual
and related bulletins and letters. I was vice-chair of the firm’s Committee on
Accounting Practice. I also served as an SEC reviewing partner. As the partner in
charge of the Accounting Group and as an SEC reviewing partner, I was extensively
involved in consultation with engagement partners in the firm’s operating offices on
financial accounting and reporting issues and with the staff of the Securities and
Exchange Commission and various banking and savings and loan association
regulators.

While in DPP, I was the firm’s representative for about eight years on the AICPA’s
Accounting Standards Executive Committee, which I chaired for three years. The
Accounting Standards Executive Committee is the AICPA’s senior technical
committee authorized to speak for the AICPA on all accounting matters. That
committee prepares statements of position and clears all AICPA Accounting and
Audit Guides and other documents that speak to accounting matters. As chair of the
Accounting Standards Executive Committee, I was an observer at meetings of the
FASB’s Emerging Issues Task Force with the privilege of the floor but no vote. As
chair of the Accounting Standards Executive Committee, I was a member of the
Financial Accounting Standards Advisory Council for three years.

While in DPP, I worked on dozens of important accounting issues for both the
firm and the profession. But one issue stands out in my mind as the most
important, from the standpoint of both KPMG and the profession. This particular
issue had a life span of ten to twelve years, so I will describe it only briefly.

After the second Arab oil embargo in 1976, asset prices began to spiral upward in
the USA, and interest rates began to climb. KPMG was at that time the dominant
thrift auditor in the profession, serving as auditor to thrifts having about 45 percent
of total thrift deposits. The thrift industry invested primarily in thirty-year mortgage
loans and funded its asset base with short-term deposits. In or about the late 1970s,
insurance for deposit accounts was raised by Congress from $40,000 to $100,000. At
about the same time, brokers such as Merrill Lynch were allowed to broker deposits,
which theretofore had been gathered only at the local level. Short-term interest rates
rose to very high levels, in excess of the rates that many in the thrift industry were
earning on their investments in mortgage loans. At or about this same time, thrifts
were allowed to invest in loans secured by land and land acquisition, development,
and construction projects—at 100 percent of the value of the underlying collateral.
Anxious to eliminate or reduce their negative spreads (paying more in interest on
deposits than they were earning in interest on their loan portfolios), many thrifts
began to make so-called loans on ADC projects. These thrifts funded 100 percent
of the developers’ cost of land and improvements to the land. Because the project
owners had no investment in the ADC projects other than their sweat, the project
owners were willing to “pay” large up-front points to the thrift lender, sometimes as

MARK TO MARKET ACCOUNTING 25

much as 5, 6, 7, or 8 percent of the amount of the loan; the “payment” was not
made in cash but was added to the loan balance or deducted from the loan
proceeds. Then, as construction proceeded, interest during construction was added
to the loan balance as well as construction “draws.” At the end of the construction
phase, the balance of the construction loan—cash advanced to the ADC project
owner plus points plus accrued and uncollected interest—was rolled over into a
semi-permanent loan. The interest rate being charged by the thrift lender was very high
—greater than the thrift was paying on its deposit accounts. In addition, in many
cases, the thrift lender would, on the ultimate sale of the project, participate with
the ADC project owner in the profits on the sale of the project. The thrifts were
crediting to earned revenue the uncollected up-front points and the accrued but
uncollected interest.

We at KPMG saw all this revenue piling up in the balance sheets of the thrift
lenders as uncollected points and interest and concluded that the thrift lenders were
in fact jointly venturing with the ADC project owners in the ADC projects. So,
early in 1983, we stepped hard on the revenue-recognition brakes and notified our
thrift clients that no more revenue could be recognized until the ADC projects were
sold and cash was collected. Well, everyone went through the windshield. Our
clients screamed bloody murder.

We notified all the other major accounting firms, the thrift regulators, and the
staff of the SEC of our position. Many thrift regulators were taken aback. The other
accounting firms thought we were daft. Too far out in front, one of them told me.
Of course they were happy to take our clients. Fortunately, not too many clients left
our firm, although many were extremely unhappy. But we did not get some
prospective new clients when our position became known to them. (Tom Holton
was chairman of the firm at this time.)

It took the rest of the profession and the thrift regulators and the SEC several
years to come to the same position that KPMG had in early 1983. But, by then,
huge amounts of reported revenue had piled up in thrift balance sheets as
uncollected receivables for points and accrued interest. In the savings and loan bail-
out by the US federal government in the late 1980s, the US taxpayer paid for that
faulty asset/revenue recognition. Ultimately, in the early 1990s, the large accounting
firms that were auditors to the thrift industry paid the US government huge
amounts of money as a result of having certified thrift financial statements that
included those faulty receivables and revenue. But not KPMG, because of the stand
we had taken in 1983.

I was appointed chief accountant to the Securities and Exchange Commission in
January 1992 and served in that capacity until March 1995, when I retired for the
first time.

Richard Breeden was the chairman of the SEC in 1992. The commission, in
testimony that Richard Breeden had given to Congress in September 1990, had
taken the position that commercial banks should mark to market their bond
holdings, which up till then banks had reported at amortized cost. I had for many
years promoted the idea that banks and other entities should mark to market their

26 WALTER P.SCHUETZE: AUTOBIOGRAPHY

assets, so my views and Richard Breeden’s views were in sync, I spent a lot of time
from January 1992 through March 1995 convincing banks, banking and thrift
regulators, and the FASB that banks, thrifts, and insurance companies should mark
to market their bond holdings.

The chief accountant is the SEC’s principal adviser and spokesperson on matters
involving accounting and auditing. The Office of the Chief Accountant monitors
the activity of the Financial Accounting Standards Board and the AICPA’s
Accounting Standards Executive Committee, Auditing Standards Board, and SEC
Practice Section, which includes the Public Oversight Board, to determine whether
those bodies are acting in the public interest. As chief accountant, I attended meetings
of the FASB’s Emerging Issues Task Force and the Financial Accounting Standards
Advisory Council with the privilege of the floor.

The chief accountant interacts with the staff of the US Congress, the staff of the
General Accounting Office and the Comptroller General, and the staffs of other
federal regulatory agencies such as the Federal Reserve Board, the Comptroller of
the Currency, the Federal Insurance Corporation, and the Office of Thrift
Supervision.

The chief accountant, in the day-to-day administration of the securities laws, has
the final say on accounting and related disclosure by corporate registrants, and a
significant amount of my time was spent on corporate registrants’ accounting and
disclosure problems. My decisions could, of course, be appealed by registrants to the
chairman of the commission and ultimately to the full commission. In the three
plus years that I was chief accountant, only one of my decisions was appealed to the
chairman, and he reversed my decision. I will describe that situation briefly.

A very small company was in the business of originating “reverse mortgage loans,”
which is an instrument whereunder senior citizen homeowners can monetize the
equity in their homes primarily in order to meet day-to-day cash needs. The lender
makes periodic, generally monthly, cash advances to the homeowner. When the
homeowner dies, the home is sold, and the proceeds are used to repay the lender’s
cash advances plus interest, with any remaining balance going to the heirs of the
homeowner. If the proceeds on sale are insufficient to repay to the lender the
amount of cash advances plus interest, the lender bears the loss.

This company wanted to “go public” through the offering of common stock.
This company’s major asset was its portfolio of reverse mortgage loans. Accounting
for the portfolio of reverse mortgage loans was critical.

The company had accounted for the cash advances as loans and had added the
amount of contractual, uncollected interest to the balance of the loan. The company
credited earned interest revenue with the amount of the contractual, uncollected
interest. I took exception to the company’s accounting. I told the company that it
should account for the reverse mortgage loan as an investment in real estate; thus,
contractual interest would not be credited to income. Instead, on the owner’s death
and sale of the home, gain or loss would be recognized at that time. I took this
position because of two factors. One, the company was exposed to what is called the
risk of adverse selection. What this means is that the company’s homeowner

MARK TO MARKET ACCOUNTING 27

borrowers were likely those who were in very good health and thus would outlive
the actuarial tables, thereby saddling the company with the risk that cash advances plus
accrued interest over a very long period would be greater than the proceeds on sale of
the home at the owner’s death. Second, the company was exposed to garden-variety
real estate risk; that is, the value of the home might decline, thereby exposing the
company to the risk that proceeds on sale of the home upon the owner’s death
would be less than cash advances plus uncollected interest.

One of these risks, namely real estate risk, was the same as the savings and loans
had faced with ADC loans as discussed above. Moreover, and more importantly, the
entire cash proceeds to this company would come from the sale of real estate, not
from the borrower’s cash flow as in the case of other, normal lending.

Although this company was very small, the company’s founders were well
connected with the senior citizen, banking, and housing lobbies in Washington.
Moreover, the business of reverse mortgage lending was just getting started and,
politically, a lot of very prominent people in Washington and elsewhere very much
wanted this little company’s initial public offering to be a success. My accounting
meant that this company’s income statement looked very sickly, and the initial
public offering, which was keenly anticipated, would not come off. The company
and its followers appealed to the chairman, who instructed me to accept the
company’s original accounting. I think that the chairman knew that my accounting
was correct, but he was unwilling, at that time, to take on another political
challenge in addition to the opposition he was facing in the banking industry in
getting the banks to mark to market their bond portfolios. I decided to accept the
chairman’s instructions and not resign my position as chief accountant, primarily
because the company was very small and there were no other companies with a
similar asset base where there would be a similar problem. In addition, I very much
wanted to succeed in getting banks to mark to market their bond portfolios, and I
could not do that if I resigned.

Interestingly, as I write this piece in 2002, the federal government now has an
insurance program available to reverse mortgage lenders whereunder the lender may
buy insurance from the government at a very low, government-subsidized price to
cover any shortfall in the proceeds upon the death of the homeowner, which would
protect the reverse mortgage lender against the risks I have described above. The
apparent reason for the insurance program is that Congress must have concluded
that reverse mortgage lending is desirable and that the risks need to be taken on by
the federal government in order to encourage this type of lending. This program
came into being after my encounter in the early 1990s with the small company
described above.

Between March 1995 and November 1997, while in retirement, I delivered a few
lectures on accounting subjects to students of St Mary’s University in San Antonio,
Texas, and the University of Southern California in Los Angeles. Also, while in
retirement, at the invitation of the AICPA, I served on the International Accounting
Standards Committee’s steering committee dealing with intangible assets, business

28 WALTER P.SCHUETZE: AUTOBIOGRAPHY

combinations, and impairment of assets. I resigned from that steering committee
when I rejoined the staff of the SEC.

In November 1997, I came out of retirement when I was appointed chief
accountant of the Enforcement Division of the SEC, which position I held until
mid-February 2000, when I retired again.

The chief accountant of the Enforcement Division of the SEC oversees those
aspects of SEC investigations and administrative proceedings dealing with audit and
accounting matters, including auditor independence. The SEC’s enforcement cases
involve civil law. The chief accountant also becomes involved sometimes, on a
consultative basis, in investigations and prosecutions by the US Justice Department
and various state law enforcement authorities into securities law violations involving
criminal law, particularly in cases involving parallel investigations and prosecutions
of securities law violations by both the SEC and criminal authorities. The
involvement with criminal authorities is fairly slight, but it is significant.

At the time of this writing in 2002, I am retired. From March 2000 through
March 2002, I was a consultant to the Enforcement Division of the SEC.
Currently, I serve on the boards of directors of Computer Associates International
Inc. and TransMontaigne Inc. and chair their audit committees. I am also an expert
witness on accounting and auditing matters in several litigations. In August 2002, I
was appointed an executive in residence at the School of Business at the University
of Texas at San Antonio.

My mother is now 87 and still lives in the town where I was born. My father died
in 1976. My sister and two brothers also live in Texas.

My wife Jean and I live in a small town called Fair Oaks Ranch, Texas (mailing
address is 8940 Fair Oaks Parkway, Boerne, Texas 78015), twenty-five miles from San
Antonio airport and twenty-five miles from Comfort. We have three boys, aged 44,
43, and 39, and two grandchildren, aged 16 and 8.

Addendum

One day, in our many conversations about accounting and auditing, Peter Wolnizer
asked me how I had got onto mark-to-market accounting (MTMA). He said to me,
“You surely did not learn mark-to-market accounting in college. How did you come
upon it?” So I decided to write this addendum to try to explain how I got onto it

Well, no, I did not learn about MTMA in college, but, for reasons that I don’t
remember, I had thought about it a lot in college. I remember my first days and
years at Eaton & Huddle in San Antonio, when the young staff would gather at
lunch and talk about accounting. I remember talking about and promoting MTMA
as to assets in those sessions in the 1950s. Tom Holton will attest that I have been
talking about and promoting MTMA as to assets since the 1950s. I remember doing
audits of the financial statements of oil and gas companies in the 1950s and 1960s
and how we accountants argued interminably about the correctness of successful
efforts accounting versus full cost accounting and how we pushed numbers around
on yellow working papers when the whole exercise was pointless in that what

MARK TO MARKET ACCOUNTING 29

investors really wanted to know was the quantities of oil and gas reserves held by the
reporting enterprises and the values of those reserves. I remember doing audits of
the financial statements of insurance companies where bonds were accounted for at
cost and where management could manage earnings at will by deciding when to sell
bonds and thus time the recognition of gain or loss. I remember interminable
arguments about deferring gains and losses on the sale of bonds and adding or
subtracting the loss or gain to the cost of the replacement bonds and then
amortizing the deferred gains and losses as adjustments of interest income, and I
thought we should just mark the bond holdings to market so that investors could
see the results of changes in market prices right on the faces of the financial
statements.

I remember endless arguments in the 1960s as the Accounting Principles Board
debated the relative merits of pooling-of-interest and purchase accounting and
wondered why we did not just mark to market all of the assets and liabilities of both
the acquiring and acquired corporation and stop the arguments.

I was a member of the Financial Accounting Standards Board from April 1973
through June 1976. When the board addressed accounting for marketable securities
in 1974 and 1975, the result of which was FASB Statement 12, “Accounting for
Certain Marketable Securities” (which has now been superseded), I wanted to
require that all marketable securities be marked to market. So did two other
members of the board, Arthur Litke and Robert Sprouse. But the other four members
did not; they wanted lower of cost or market for each portfolio of securities. Because
the board at that time needed five votes to issue a standard and because the board’s
constituents said that a standard, some standard, was needed because of the diversity
in practice, I decided to bite my tongue, not dissent, and agree to the issuance of
Statement 12, which required lower of cost or market for each portfolio of securities.
Statement 12 was an awful standard; lower of cost or market is simply not a relevant
number. I got so frustrated with the board over Statement 12 that I decided to leave,
which I did on June 30, 1976. The market prices of marketable securities are always
relevant. And those prices are very easy to obtain, generally just by looking in the
Wall Street Journal. I concluded that if the board would not agree to MTMA when
getting the number was as easy as looking in the newspaper then there was little hope
of my persuading the board of the relevance of MTMA in situations other than
those involving marketable securities. So I left the board.

I stumbled around, mentally, for a number of years over how to deal with
liabilities such as bond liabilities and pension liabilities. Should the bond liability be
reported at the amount of original proceeds adjusted for amortization of discount or
premium, or should the bond liability be adjusted to the market price at each
balance sheet reporting date? Should the pension liability, that is the vested pension
liability, be reported at its discounted amount using the risk-free rate or the rate
implicit in the liability assuming settlement with the pensioner at the balance sheet
reporting date? I had argued to the Financial Accounting Standards Board in 1995
and to the International Accounting Standards Board in 1997 that the discount rate
should be the risk-free rate. In a most persuasive letter of response to me in 1997

30 WALTER P.SCHUETZE: AUTOBIOGRAPHY

(which unfortunately I have since lost), Sir Bryan Carsberg of the International
Accounting Standards Board argued that the rate should be the rate that takes into
account the obligor’s credit standing. As a result of Carsberg’s letter, I changed my
mind. Restated by me, the pension liability is the amount of cash that the pensioner
would accept, given the obligor’s credit standing, in settlement of his/her vested
pension benefits. Thus, conceptually, both the pension liability and the bond
liability are reported at their estimated cash settlement prices at the balance sheet
reporting date. I have since referred to this amount as the current cash settlement
price of liabilities.

Despite the fact that the Financial Accounting Standards Board and the
International Accounting Standards Board have not endorsed MTMA, I have not
given up on MTMA. I continue to believe that current market prices of assets and
current settlement prices of liabilities are the most relevant information that
accountants can provide to investors, as set out in various pieces in this anthology. See,
for example, “True north” appearing in Abacus in February 2001, my Chambers
Lecture in November 2001, and my US Senate Banking Committee testimony in
February 2002.

Let me just close by saying that the historical cost of assets and the historical
proceeds of liabilities, which is the way reporting is mostly done today, are seldom
relevant and are often misleading to investors. Current selling prices of assets and
current settlement prices of liabilities are never misleading and are always relevant to
investors. That is the kind of accounting that my sister would understand.

MARK TO MARKET ACCOUNTING 31

Part I

Accounting for assets and liabilities

3
Schuetze on accounting for assets and liabilities

Peter W.Wolnizer

This section contains Walter Schuetze’s major intellectual and practice-informed
contributions to accounting. It is here that he makes a cogently argued case for the
adoption of mark-to-market accounting. With care and insight informed by an
extensive experience of accounting practice, standard setting and corporate
regulation at the highest levels, he establishes the practical foundations for valuing
assets at their current selling prices and liabilities at their current settlement prices.

Schuetze deals with fundamental accounting matters—the definition and
quantification of assets and liabilities. He tackles the most vital, but still
problematical and controversial, questions at the heart of corporate financial
reporting— the representation of a company’s dated financial position or state of
affairs and a company’s periodic financial performance or profit/loss. However, he
reaches beyond these big questions to deal with accounting regulation generally and
with several specific accounting matters, such as accounting for restructurings, good
will, stock options, asset impairment, contingencies and financial instruments. In
many ways, it is in his incisive analytical dissection of particular, but complex,
accounting matters that Schuetze’s already compelling case for mark-to-market
accounting really shines.

Comprising three articles, six speeches and fifteen letters, this is the largest section
in the book.

The articles

These articles are substantial contributions to the literature not for their content
alone but because they are from the pen of a practitioner whose views are informed
not so much by theoretical argumentation as by observation and experience of what
style of accounting works—and informs investors’ choices—in practice. Hence we
find a plea to those responsible for promulgating accounting rules and standards to

“Keep it simple”—the title of his first article in Accounting Horizons (1991) but a
recurrent theme throughout his writings in this section. A recurrent theme, yes, but
one richly and poignantly illustrated by reference to a plethora of APB Opinions
and FASB Statements, including FASB Statement 133 (derivatives and hedging
instruments), Statement 96 (income taxes), Statement 87 (pensions) and Statement
13 (leases).

While he observes, in various places, that the accounting standards issued by the
FASB are “far too complicated,” “vastly too voluminous,” “too detailed,” “too
abstruse” and of “mind-numbing complexity,” he looks for elegant solutions that
work—“simple bright-line rules” he calls them. He argues that the idea of simplicity
should be transported to the conceptual framework—and he does, starting with
perhaps the most basic question, the definition of an asset.

The FASB definition of an asset, as “probable future economic benefits obtained
or controlled by a particular entity as a result of past transactions or events,” he
describes as “an abstraction” and “mind-boggling stuff”:

Most accountants do not understand it. Ordinary folk are mystified by it. We
have not been able to solve accounting problems by using that definition.
Almost any expenditure fits into that definition because it does not
discriminate. We need a simple definition. How about defining assets as
CASH, contractual claims to CASH and things that can be sold for CASH?
That definition would do away with goodwill, pre-opening costs, employee
training costs, and other junk now called assets.

He elaborates: “Abstractions—probable future economic benefits—cannot be sold
for CASH. Only real things can be sold for CASH. Only real things can be assets.”
It is clear that exchangeability (for cash) is the crucial attribute of an asset. In this
article, he argues that assets should be measured at “current value, i.e. the price of the
assets in a current sale for CASH, at least for financial instruments.” Later, he
elaborates on current value or fair value: “I would define fair value of assets as follows:
the estimated amount of cash the asset would fetch in an immediate sale whether or
not under duress, without recourse or guarantees, less the estimated amount of cash
that would have to be paid out to accomplish the sale.”

Schuetze developed this line of argument further in a speech delivered at the 20th
Annual National Conference on Current SEC Developments in Washington in
January 1993, when he was chief accountant to the SEC. That speech, published as
“What is an asset?” in Accounting Horizons (1993), was delivered against the
background of the SEC promoting mark-to-market accounting for marketable debt
and equity securities to the FASB and the financial community. Having attended a
conference for accounting standard setters from around the world at the FASB
following the World Congress of Accountants in Washington in October 1992, he
states that he was “taken by the lack of agreement on basic concepts about financial
accounting and reporting. One of those conceptual issues is the definition of an

34 MARK TO MARKET ACCOUNTING

asset. It is clear that one of the major roadblocks to resolving accounting issues here
in the United States is lack of agreement on the definition of an asset.”

The FASB’s definition of an asset, he argues, is “so all-incluisive and so vague
that we cannot use it to solve problems. It does not require exchangeability, and
therefore it allows all expenditures to be considered for inclusion as assets. That
definition does not discriminate and help us to decide whether something or
anything is an asset. That definition describes an empty box. A large empty box.

…Almost everything or anything can be fit into it. Some even want to fit losses
into the definition.” It comes as no surprise when, as chief accountant to the SEC,
he revealed that:

We see situations at the Commission, particularly in enforcement cases, where
there are long-winded briefs by registrants, their lawyers, their independent
auditors, and their expert witnesses quoting extensively from the FASB’s
Concepts Statement 6 to support a debit balance in the balance sheet as a fit
and proper asset, fully meeting the FASB’s definition of an asset. One sees
even longer, long-winded briefs in private, civil litigation. In that litigation,
both sides, and all of their expert witnesses are citing the same passages from
the FASB’s Concepts Statement 6 in support of their positions regarding the
worthiness or unworthiness of a debit balance in a balance sheet as an asset.
What we have, then, in the lawyers’ words are teams of swearing accountants
—one swearing “thus and so” and another swearing “such and that”—and
they cannot resolve what should be a simple question: whether something is
an asset.

And nearly another decade has passed, and nothing has changed.
In “What is an asset?” he expands his definition of an asset to include “contractual

claims to services,” an addition he subsequently deleted in “What are assets and
liabilities? Where is true north? (Accounting that my sister would understand)”
(Abacus, February 2001).

Defining assets in terms of exchangeability and measuring them at their current
market selling prices “would vastly simplify the practice of accounting… would
appeal to investors and other users of financial statements…would appeal to
ordinary men and women who walk up and down Main Street… would dispense
with all of the long-winded briefs about the fitness of debit balances as assets and
the teams of swearing accountants…would tend to make balance sheets less prone to
challenge and thereby reduce litigation against registrants and auditors. It would
make balance sheets rock solid.”

In this latest and most comprehensive article, he elucidates his views about the
definition and quantification of assets and liabilities in a formulation he calls “true
north.”

Building the case for simplicity in accounting, he outlines the voluminous body of
literature that constitutes “generally accepted accounting principles”— the FASB’s
Statements on Financial Accounting Standards, Accounting Research Bulletins

ACCOUNTING FOR ASSETS AND LIABILITIES 35

issued by the AICPA and the APB Opinions, in addition to the FASB’s “special
reports” and the “consensuses” issued by the FASB’s Emerging Issues Task Force. He
claims that the “volume and complexity of those pronouncements have become
overwhelming—on a par with the Internal Revenue Code and the related regulations
in the USA” and “too much for (a) those insiders who are responsible for and
prepare financial statements and reports, (b) those outsiders who audit those
financial statements and reports, (c) those outsiders such as investors, creditors,
underwriters, boards of directors and audit committees, and analysts who use those
financial statements and reports, and (d) those outsiders who regulate the
preparation, audit, and dissemination of financial statements and reports.” The
result, he declares, is “a cacophony… nothing but noise. It is as if each musician in
the orchestra is playing from his or her self-selected sheet of music, one of the Three
Tenors is singing in Italian, the second in German and the third in French, all
without a conductor.”

So he looks for accounting rules that “ordinary folk” can understand and apply:
an “accounting that my sister would understand.” Such an accounting must be
intelligible to “ordinary people, chief executive officers, line operating managers,
members of boards of directors, investors and creditors and regulators, who are not
accountants.” Why? Because “it is the non-accountants who use financial statements
and reports to make investment, credit, and regulatory oversight decisions, not to
mention corporate governance decisions.”

Having dealt with the definition and measurement of assets, he turns to
liabilities. He argues that the FASB’s definition of liabilities as “probable future
sacrifices of economic benefits arising from present obligations of a particular entity
to transfer assets or provide services to other entities in the future as a result of past
transactions or events” (FASB Concepts Statement 6, para. 35) “is as infirm as its
definition of an asset. …We cannot solve the question, at the margin, of what is and
what is not a liability because the definition is so openended.” Schuetze proposes an
alternative definition: “I suggest that we define liabilities by reference to future cash
outflows required by negotiable instruments, by contracts, by law or regulation, by
court-entered judgments or agreements with claimants, and derivative contracts
having a negative value.” He would value liabilities at “fair value,” which he defines
as “the least amount of cash that the counter party would accept in an immediate
and complete liquidation of his/her claim against the reporting enterprise.”

Such an accounting, says Schuetze, would be simple. “It would have a simple,
singular focus—cash. All assets and liabilities would be stated at fair value. We all
would know where north lies on that accounting compass.”

The speeches and addresses

The six speeches and addresses in this section, dating from 1992 to 2002, were
delivered to diverse audiences including accounting and legal practitioners,
academics, accounting standards setters, and regulators, students and politicians.

36 MARK TO MARKET ACCOUNTING

The first, delivered on 7 January 1992 to the 19th Annual AICPA National
Conference on Current SEC Developments in Washington, was his maiden speech
as chief accountant of the SEC. He called it “New chief accountant’s wish list.” In
crisp focus were the two related themes of simplicity and relevance in financial
accounting and reporting. In a fresh approach to these desirable objectives in
accounting, he said:

I suggest that we all stand back and try to put ourselves into the shoes of the
investor and creditor and ask whether this welter of complexity that we
have created [generally accepted accounting practices], and continue to create,
really helps those people to make lending and investing decisions. My
judgment is that we have gone too far.

He suggests that we have arrived at voluminous and complex accounting rules
because broad, general standards do not work:

At best, that approach results in extensive non-comparability amongst and
between reporting entities. At worst, that approach results in abuse and
perhaps even fraud. People will, in good faith, interpret broad, general rules in
just that way: some people will be conservative, some liberal, and some in
between; and that provides wide non-comparability in financial reporting.
Given that kind of broad, general standard, independent auditors have no
benchmark or guideline to judge whether their clients have complied with the
standard or rule. …Investors and creditors need to be able to make
comparisons among and between alternative investments, and we should help
them do that, not make it difficult or opaque.

This leads him to suggest that standards have some bright lines “that will result in
uniform application of the standards and comparability among and between
reporting enterprises, not only in this country but others as well.”

From a call for simplicity in accounting rules, Schuetze proceeds to call for
relevance in financial reporting and mark-to-market accounting—in full support of
the commission’s advocacy of mark-to-market accounting for financial institutions
as set forth by SEC Chairman Breeden in testimony before the US Senate
Committee on Banking, Housing and Urban Affairs of the United States on 10
September 1990. “My views about mark-to-market accounting versus historical cost
are on all fours with the views of the commission as articulated in the 1990
testimony. Indeed, I will go one step further and suggest that this issue has been
studied enough in the laboratories of academic journals and needs to be tested in the
crucible of practice.” He concludes that “Market value information about assets and
liabilities, intuitively, has to pass everyone’s test of relevance.” Simplicity in
accounting rules, relevance for financial decision making and mark-to-market
accounting “go hand in glove.”

ACCOUNTING FOR ASSETS AND LIABILITIES 37

In the second speech, delivered at the annual meeting of the American
Accounting Association on 12 August 1992, he sets forth six reasons why historical
cost accounting should be “jettisoned” and mark-to-market accounting adopted for
marketable securities: (1) to enhance usefulness for investment or lending decisions;
(2) to stop income or earnings management; (3) to recognize the effectiveness of
managing interest rate risk; (4) to recognize credit losses as the credit standing of
bond issuers declines; (5) to enhance market efficiency; and (6) to report accurately
on capital adequacy.

He illustrates the misleading outcomes of using historical cost accounting by
reference to the savings and loan debacle. “The use of historical cost did not cause
the S&L problem, but the use of historical cost is to blame for the loss of some of that
money down the S&L hole. …If the S&Ls had been forced to disclose, never mind
account for, the fair value of their ADC [acquisition, development and
construction] portfolios and their bond and mortgage loan portfolios, does anyone
honestly believe that the S&L hole would have gotten as deep as it got? I think the
fair answer to that question is ‘No’.”

The speech concludes with a challenge to the profession to “pull on its own
bootstraps,” to deal with the underlying causes of litigation against itself:

The profession will not go to its clients and tell those clients that their balance
sheets have to have realism in order to elicit unqualified opinions. …The
profession, again with an exception or two, will not go to the FASB and
support realism in financial accounting and reporting. The profession will not
reach tough and unpopular decisions. Why is that? Is it because the profession
has become so beholden to its clients that it will not speak to them about
realism and relevance and credibility in financial accounting and reporting?

This argument will be picked up again in the next section. Suffice it to say at this point
that Schuetze illustrates his point with five—of many possible—situations where the
profession has “become a cheerleader for its clients”: troubled debt restructurings,
pension plan values, deferred tax assets, investment versus trading and SEC filings.

His plea to the profession is “to give some thought to the public that it serves, to
the investors and creditors and employees who put up their money and their labor
to make investments in the profession’s clients.” His plea to the FASB and the
profession is “to address the issues of relevance and credibility in financial
accounting and reporting so as to maintain their own relevance and credibility.” A
timely clarion call to the accounting profession and standards setters indeed.

Schuetze’s address to the Theta Chapter of Beta Alpha Psi at the University of
Texas at Austin on 12 November 1993, on the occasion of their naming him
Accountant of the Year, expounds the vital role that accounting plays in capital
markets: “Accounting is the lubrication that allows this country’s capital markets
engine to turn at very high RPMs without overheating.” He explains how public
and private companies, state and local governments, churches and temples, colleges
and universities, and charitable organizations all need and use accounting and

38 MARK TO MARKET ACCOUNTING

accountants. And he leaves those bright, aspiring accountants with an observation
and sage advice: “the one thing that I have found to be the most important as I have
traveled through this world of business and accounting for thirty-six years. That is,
high ethical standards. …It has been my observation that those who are the most
fulfilled are those who not only do good work but who do it on the up and up, on
the straight and narrow, with no corners rounded. It is they who are sought out
most often by their colleagues, by their superiors, by their clients, by new clients, by
the public.”

The fourth and sixth speeches deal with accounting for restructurings. They were
delivered to the Financial Executives Institute in New York on 8 November 1994
and the 19th Annual Ray Garrett Jr Corporate and Securities Law Institute at
Northwestern University on 22 April 1999. The 1994 speech is set against the
background of the SEC’s request to the FASB’s Emerging Issues Task Force to
address accounting for restructurings. Schuetze had observed the substantial growth
in the number of restructurings and the concomitant increase in restructuring
charges. He had also observed that while a large proportion of those charges related
to employee-related costs, the ingredients of restructuring charges were diverse,
including a variety of write-downs and write-offs of costs incurred in past periods,
and expenditures expected to be made in the future for the benefit of future
operations.

Noting that as a charter member of the FASB he had signed FASB Statement 5
dealing with accounting for contingencies, he explains how he would account for
restructuring charges, exit costs and related balance sheet liabilities or reserves. He
argues that accounting for restructurings has become an abuse and states that the
FASB’s definition of a liability in FASB Statement 6 would not accommodate
liabilities recognized pursuant to management’s declaration in a restructuring and
that such liabilities amounted to contingency reserves that are precluded by FASB
Statement 5. Consequently, he argues that the Emerging Issues Task Force should
not approve such accounting for restructurings. Notwithstanding that advice, nine
days later, on 17 November 1994, the Emerging Issues Task Force approved the
establishment of restructuring reserves.

In the speech delivered at Northwestern University, he again addressed
accounting for restructuring charges and restructuring reserves—one of the
accounting “hot spots.” He suggests that a better title for the speech may have been
“Accounting for general reserves, contingency reserves, rainy day reserves, or cookie
jar reserves.” Lacking a robust definition of what constitutes a restructuring, he
notes that “Accounting for so-called restructurings has become an art form” because
restructuring charges are frequently reported below the line. Hence earnings are
reported before charges. In other words, accounting for restructurings has become
just another way of manipulating earnings.

He points out that two consensuses of the FASB’s Emerging Issues Task Force
that deal with the recognition of liabilities on the occasion of a restructuring or
merger (EIFT 94–3 and 95–3) “allow for the recognition of liabilities based on a
representation by management that the company will make certain expenditures but

ACCOUNTING FOR ASSETS AND LIABILITIES 39

before a cash outflow is required pursuant to a law or a contract. In all other cases
except in accounting for pensions and OPEBs, liabilities are not recognized until
some event has occurred and a cash outflow therefore is required, either by law or
regulation or under an enforceable contract.” Furthermore, companies may establish
reserves for some restructurings and not for others. And the numbers ascribed to
those reserves, being management’s assertions, cannot be verified by the auditors.

In his 1999 speech on restructurings, he states:

Well, my instinct in 1994 has been confirmed by practice. What has
happened since 1994 is that general reserves, contingency reserves, rainy day
reserves, and cookie jar reserves, now are in vogue for those who want to use
them. Based on what I see in the Enforcement Division [of the SEC], there
apparently is no limit to what ingredient may be included in the reserves or
the amount ascribed to it.

The fifth speech, delivered at the 1998 annual meeting of the American Accounting
Association, deals primarily with the question of whether purchased goodwill is an
asset. Before tackling that question, however, he opens with the theme of cooking
the books by using examples such as premature revenue recognition, deferral of
operating costs, and recognition of treasury stock and barter trade credits as assets.

In that context, he returns to the use of reserves to manipulate earnings:

I have found that reserves are like crab grass. They are everywhere. …Need a
penny a share to meet Wall Street’s expectations? Need two pennies? A
nickel? A dime? Two bits? Dip into the chocolate chip cookie jar reserve. The
mere existence of reserves is a chocolate chip cookie jar that management
cannot resist when the earnings need a sugar high. We need to fix reserve
accounting. It’s time to make another pass at reserves; we need a Year 2000
version of FASB Statement 5.

Schuetze notes that the FASB had tentatively concluded that the cost of purchased
goodwill meets the board’s definition of an asset With careful and skilful analysis, he
demonstrates how purchased goodwill fails to meet all the criteria set forth by the
board in Concepts Statement 6 for the recognition of an asset. Calling the cost of
purchased goodwill “the lump,” he demonstrates that the lump is not a future
economic benefit; the lump is just a cost, nothing more; the lump cannot be
controlled; the lump cannot be measured reliably. The lump cannot be used to
produce anything of value. The lump cannot be used to settle a liability. Using the
board’s own words, he demonstrates that the future economic benefit criterion of an
asset is not met in the case of goodwill.

40 MARK TO MARKET ACCOUNTING

The letters

There are fifteen letters in this section. They are addressed to the FASB, IASC,
Barrons Magazine, Journal of Accountancy (submitted when Schuetze was in private
practice and withdrawn in January 1992 when he was appointed as chief accountant
to the SEC); and to Sir Bryan Carsberg and Senator Charles Schumer. These letters
are packed with illustrations, examples and analogies that bring life to the analytical
argumentation. They are compelling reading.

Dating from 1986 to 2002, the letters cover a wide range of topics, including
accounting for goodwill, asset impairment, liabilities, contingent liabilities, trans-
fers of receivables and stock options, the discount rate to be used in determining
pension liabilities, and the disclosure of market values of financial instruments.

The letters to the IASC (18 September 1997) and FASB (15 June 2000 and 16
March 2001) are responses to exposure drafts dealing with internally generated and
purchased goodwill. His letter to Barrons Magazine is on the same topic. In those
letters, he analyzes why internally generated and purchased goodwill should not be
capitalized. He argues that costs are not assets, even under the conventional
accounting definition of an asset, and that goodwill is neither separable from the
enterprise nor exchangeable for cash.

In his letters to the FASB, he calls the cost of purchased goodwill “a glob” and
argues that the recognition of the glob as an asset is precluded by the FASB’s own
words in Concepts Statement 6. He also argues that goodwill represents expected,
“hoped for future profits,” which are “contingent gains” that should not be
recognized as assets until they are earned and in the hand as cash or something that
can be sold for cash. He urges the FASB to go back to first principles and to re-examine
its definition of an asset. In particular, he argues that exchangeability should be the
crucial test for recognizing something as an asset. Goodwill, he demonstrates, is not
exchangeable in and of itself for cash. In his letter to Barrons Magazine, he argues
that the vast majority of CPAs do not understand the FASB’s definition of an asset:
“Only FASB accountants know what it means, but they can’t explain it in plain
English that my sister, who runs a successful business, can understand.”

He argues that the IASC and FASB exposure drafts on internally generated
intangible assets and purchased goodwill “will not work”: “There will be no
comparability whatsoever in the accounting from one enterprise to another for
internally generated intangible assets. Investors will not be well served. …What will
work is a requirement to charge to expense when incurred all costs related to internally
generated intangible items and purchased goodwill.” He argues that:

Two rationales support this approach, both of which fit within the IASC’s
framework. One rationale is that costs per se are not assets and should not be
recognized as if they were assets…The other rationale is that the…future
economic benefits from expenditure (or fair value of securities issued) for
intangible items that are not separable and saleable and for which a fair value
cannot therefore be established are so indeterminate and so speculative that

ACCOUNTING FOR ASSETS AND LIABILITIES 41

expenditure (or fair value of securities issued) for such items should not be
represented as an asset.

In his letters of 23 July 1997 to the IASC and 7 November 2000 to the FASB,
Schuetze comments on exposure drafts dealing with the impairment of assets. These
are also very interesting pieces, for he addresses the fundamental differences between
“value in use” and “fair value.” By fair value, he intends “the estimated amount of
cash the asset would yield in a sale to an unrelated party, that is, a market
participant” He argues that the IASC’s proposal to require that management make
its estimate of “value in use” to determine whether the carrying amount of an asset
is impaired will produce unreliable and irrelevant information for users of financial
statements. He makes the same argument in relation to the FASB’s proposal that
impairment be determined by a comparison of management’s estimate of the
undiscounted cash flows of the asset with the carrying amount of the asset even
though the selling price of the asset is less than the carrying amount. He argues that
the carrying amount of an asset should be its fair value, or market selling price: “Fair
value is an amount that generally can be verified by reference to information outside
the enterprise and thus is reliable. Value in use, being an internal, private estimate
cannot be verified and thus is not reliable.”

He makes a telling point: “The holders of assets may do their own, internal, private
accounting any way they want to…But, the chief concern of the IASC is financial
accounting and reporting for investors and creditors. The information that is
produced for investors and creditors must be relevant to them, and the information
must be reliable (verifiable). Value in use fails on both counts.”

The 7 November 2000 letter also addresses the timing of the recognition of
liabilities associated with the disposal of assets. He points out that the FASB’s proposal
in its Exposure Draft Accounting for the Impairment of Long-Lived Assets and for
Obligations Associated with Disposal Activities is inconsistent with its own definition
of a liability in FASB Statement 6 because it would allow for the recognition of a
liability before there is a “present obligation” to pay cash to an obligee. He writes:
“We have seen enough downright awful earnings management under Consensuses
94–3 and 95–3 issued by the FASB’s Emerging Issues Task Force where liabilities may
be recognized when managements of reporting enterprises want to and then reversed
when those managements want to. The FASB itself should not issue a standard that
will allow this shoddy, reprehensible practice to continue.”

The letters to the FASB (13 February 1986), to the Journal of Accountancy
(December 1991) and to Senator Schumer (25 March 2002) also concern
accounting for assets and expenses. In his letter to the FASB, Schuetze urged the
board to require companies to disclose the fair value of all on- and off-balance sheet
financial instruments. It appears that this letter may have been very influential on the
board’s deliberations, for in a personal note to Schuetze by Halsey Bullen (16
October 1992), a senior FASB staff person, he writes: “I’m not sure how much
credit we gave you at the time, but it was [your letter] that led to our [FASB]
Statement 105 [Disclosure of Information about Financial Instruments with Off-

42 MARK TO MARKET ACCOUNTING

Balance Sheet Risk and Financial Instruments with Concentrations of Credit Risk] and
[FASB] Statement 107 [Disclosure About Fair Value of Financial Instruments].”

In his article submitted to the Journal of Accountancy in December 1991 but
withdrawn in January 1992 upon his appointment as chief accountant to the SEC,
Schuetze tackled a then pressing problem—accounting for transfers of receivables.
Against the background of the corporate collapses of the late 1980s and the
subsequent liquidity crunch, many US corporations were seeking to increase their
liquidity and equity and decrease their borrowings. Hence there was a push to get
loans, including receivables, off their balance sheets. Consequently, accounting for
receivables generally, and transfers of receivables in particular, was “hugely
important.”

In that letter, Schuetze describes how, under FASB Statement 77, transferors of
receivables who retain various risks, such as credit risk or interest rate risk, in
connection with the transfer are reporting false gains on sales of the receivables,
because Statement 77 does not require the recognition or measurement of those
retained risks by the transferor. Schuetze argues that the retained risk should be
recognized as a put liability and priced at fair (market) value at every reporting date.
He claims that the IASC’s Exposure Draft (E40) on accounting for receivables and
transfers of receivables, if adopted, would “put the accounting for receivables and
especially transfers of receivables, back into the Dark Ages.” He analyzes how the
IASC’s proposal to deal with retained risk by accounting for the transfer of the
receivable as a borrowing produces phantom assets, liabilities, revenues and expenses
in the transferor’s financial statements and those of subsequent transferors as well:
hence the reference to Tom, Dick and Harry.

In his recent letter to Senator Schumer (25 March 2002), Schuetze returns to the
problematic conventional definition of assets as future economic benefits. At issue in
this letter is accounting for stock options. Under the conventional definition of an
asset, issuance of a stock option to an employee produces an expense. Schuetze
argues that under his definition of an asset, where assets are real things and not
future economic benefits, the stock of a reporting enterprise would never be
regarded as an asset, and expenses would be the using up of an asset or the decline in
the market value of an asset. Under that scenario, the issuance of stock options to
employees would not give rise to an expense.

Letters to the IASC (9 September 1997) and FASB (1 May 2001) deal with
liabilities. Responding to the IASC’s Exposure Draft E59 on “Provisions,
Contingent Liabilities and Contingent Assets,” wherein it is proposed that a liability
be recognized when an enterprise has no realistic alternative but to transfer
economic benefits to another party, Schuetze argues that “liabilities should [only] be
recognized…when transfers of economic resources are required by law, by contract,
or because an enforceable claim exists against the enterprise and the amounts can be
measured reliably.” He claims that the IASC’s proposal is ill-founded and illogical:
“That idea could be applied in logic to tomorrow’s salaries and electricity resulting
in the recognition of a liability today for such items.”

ACCOUNTING FOR ASSETS AND LIABILITIES 43

Against the IASC’s notion that provisions and contingencies may not need to be
disclosed if such disclosure would be prejudicial to the reporting enterprise in
negotiations with another party, he argues that the financial statements of public
companies must be transparent so that investors are fully informed, and non-
disclosure should not be permitted at any price.

His letter of 1 May 2001 to the FASB concerns the board’s Exposure Draft 213-B
Accounting for Financial Instruments with Characteristics of Liabilities, Equity or Both
and its Exposure Draft 213-C, a proposal to revise the definition of liabilities. He
argues that the FASB’s proposal to require that certain obligations that must or may
be settled by issuance of the enterprise’s share be classified as liabilities is incorrect
because it “implies that a corporation’s shares, which will be used to settle the
obligation, are assets of the corporation. That is an incorrect implication.”

Referring to the FASB’s proposal (in 213-B) to require that proceeds received on
the issuance of a compound instrument be allocated to the various parts as, for
example, allocation to the equity and debt features of a bond, he states: “That’s as-if
accounting—as if a corporation had issued two instruments, a debt instrument and
an option to buy shares of the corporation, when in fact only one instrument was
issued. Financial statements should report what happened and what is, not what
might have happened and what might be.” He likens this style of accounting to
“accounting for hypothetical, as-if deferred income taxes” —just another “time-
consuming, money-consuming, hypothetical, as-if allocation that has no real world
meaning.”

In his letters to the FASB (25 September 1995) and Sir Bryan Carsberg (17 April
1997), Schuetze argues that the discount rate used for determining pension
liabilities and liabilities for nuclear decommissioning and environmental
remediation should be the risk-free rate. In conversation, Schuetze recalls that “Sir
Bryan took me to task for faulty thinking, saying that the determination of the rate
should take into account the credit standing of the borrower or obligor. Largely
based on Sir Bryan’s arguments, I changed my mind.” Schuetze now argues that
liabilities should be reported at fair value (or settlement price), which would
implicitly take into account the obligor’s credit standing. That definition is clear in
“True north.”

In many ways, his latest two letters to the FASB, dated 14 July 2002 (concerning
accounting for guarantees) and 6 September 2002 (concerning “special-purpose
entities”), demonstrate how a straightforward, rigorous application of mark-to-
market accounting would do away with the ambiguous and open-ended accounting
that currently prevails.

In the letter on accounting for guarantees, he points out that while the FASB
requires guarantee liabilities to be measured initially at fair value, it is silent about
how those liabilities should be measured subsequently. He states: “Guarantee
liabilities should always be measured and reported at fair value, and the Board
should say so. If the Board leaves the matter open, as in the proposed interpretation,
practice likely will be mixed, which obviously is not in the best interest of financial
reporting. That’s no way to run a railroad.”

44 MARK TO MARKET ACCOUNTING

The FASB’s proposed interpretation of the consolidation of certain
specialpurpose entities (SPEs) exemplifies the kind of knee-jerk accounting that
Schuetze decries. In his letter of 6 September 2002, he states:

In its determination and rush to get off-balance-sheet liabilities of SPEs onto
someone’s balance sheet after Enron’s implosion last year and the subsequent
publicity about Enron’s off-balance-sheet activities and the publicity about
the Board’s inaction for a decade or more about accounting for SPEs, the
Board now proposes to contaminate the liability side of corporate balance
sheets by putting onto corporations’ balance sheets “debt” that the reporting
corporations do not owe. In the process, the Board now also proposes to
contaminate the asset side of corporate balance sheets by putting onto
corporations’ balance sheets “assets” that the reporting corporations do not
own, cannot sell, cannot pledge as collateral, cannot give to charity, and
cannot distribute to shareholders—assets that belong to SPEs.

This section of twenty-six pieces is a rich repository of analytical arguments,
examples and illustrations that demonstrate how valuing assets at current market
selling prices and liabilities at current settlement prices would yield a more
contemporary, factual, informative and intelligible accounting not only for investors
and creditors but for all interested users of financial statements. Schuetze exposes
serious technical flaws in the conventional definitions and quantification of assets
and liabilities and demonstrates how they yield accounting fictions, inconsistent and
unintelligible accounting practices, and misleading signals for investors and other
users of corporate financial reports.

ACCOUNTING FOR ASSETS AND LIABILITIES 45

4
Keep it simple

Accounting Horizons, Vol. 5, No. 2, June 1991

The Financial Accounting Standards Board is getting a lot of advice these days. The
advice comes from the American Institute of Certified Public Accountants, the
Business Roundtable, the Financial Executives Institute, the chairmen of the large
accounting firms, the Financial Analysts Policy Committee, the Securities and
Exchange Commission and its staff, and banking and thrift regulators. I will add my
voice to the chorus. My theme (plea) in this piece is for the FASB to keep it simple.

Some of the FASB’s recent and not so recent statements are far too complicated.
FASB Statement 96 (income taxes), Statement 87 (pensions), and Statement 13
(leases) are examples of mind-numbing complexity. Those statements are so
complicated that ordinary people cannot understand and apply them. The best
analogy that I can think of is one of automobiles. When I look at FASB Statement
96 on income taxes, I see a Formula 1 racing machine. One has to be a Fittipaldi or
Luyendyk to drive a racing machine at Indianapolis at an average speed of 167 or
186mph. Most of us can handle and afford only a production-line automobile, and
the speed limit for us is 55mph (65mph in certain states), not something in excess
of 160mph.

How did we get here? How did accounting standards get so complex? Some of
the responsibility for the complexity lies with the Securities and Exchange
Commission and its staff. Regulation S-X, Regulation S-K, the various registration
forms, and the periodic reporting forms with which public companies must comply
are complicated. Over the years, the SEC has layered complexity on top of
complexity The SEC’s staff for years has written detailed letters of comments to
registrants; it is said that the staff is picking the bugs from the bed linen. Some of
the complexity arises because transactions are complex. However, by far most of the
recent complexity arises because preparers of financial statements and their CPA
firms have asked for it. An example is pension accounting (FASB Statement 87).
Pension accounting is complicated because most preparers, and their CPA firms, are
unwilling to see changes in market values of plan assets and settlement values of plan

liabilities entered into earnings as those values change. Spread those changes, they
say. A large part of FASB Statement 87 is devoted to smoothing the hills and valleys
of change. FASB Statement 106 on accounting for post retirement benefits
other than pensions is complex for the same reason. Income tax accounting (FASB
Statement 96) is complicated because the auditing profession was unhappy with a
simpler rule that left unanswered a lot of details and because old APB Opinion 11
does not fit into the FASB’s conceptual framework and had to be changed for that
reason.

We have the Emerging Issues Task Force because our current accounting rules
are not detailed enough to answer all the accounting questions that arise in a
complex business world, and the independent auditing profession wants detailed
answers to respond to pressures from clients to do things in a less than conservative
way.

The board needs to keep it simple in future statements. But the board cannot just
set forth a simple standard, state the objective of the standard and leave it to the
judgment of preparers and their CPAs to implement the standard, as it now is in
vogue to suggest.1 That approach will not work. The world needs simple bright-line
rules.

We have tried the simple approach that requires judgment. For example, in APB
Opinion 5, the Accounting Principles Board said that lessees should recognize on
their balance sheet those leases that are in substance installment purchases of
property—those that result in creation of a material equity in the property. That
was a general standard, requiring judgment to implement. It did not work. Very few
leased assets and corresponding lease obligations were recognized by lessees. As a
result, the Financial Accounting Standards Board issued very detailed, complex rules
on accounting for leases in FASB Statement 13. But now, Statement 13, even with
all its amendments and interpretations, does not work. And, to make things worse,
the Securities and Exchange Commission’s staff and the Emerging Issues Task Force
keep adding layers of complexity to it. The Accounting Principles Board, in APB
Opinion 9 on earnings per share, said that an outstanding security is a residual
security (now called a common stock equivalent) if it derives a major portion of its
value from its conversion rights or its common stock characteristic. That was a
general standard requiring judgment to implement. It didn’t work, The CPA firms
could not agree on the meaning of “major portion.” Some thought 90 percent,
others 51 percent. APB Opinion 9 had to be replaced by APB Opinion 15, which is
far too complex and needs to be simplified. The predecessor rule (Accounting
Research Bulletin 48) to the pooling-of-interest rules in APB Opinion 16 was
simple but judgmental. It did not work. And now APB Opinion 16 is not working
because its detailed, complex rules do not cover new situations not thought of when
it was issued in 1970.

FASB Statements 77 (transfers of receivables) and 80 (futures contracts) are fairly
simple but leave a lot of room for judgment. Neither one works in practice. What is
a sale and what is a financing under Statement 77 is judgmental. A fairly large
segment of Wall Street earns a living figuring out how to best the CPA firms and

MARK TO MARKET ACCOUNTING 47

Statement 77. Statement 80 allows for so much judgment about correlation and
anticipated transactions that preparers, auditors, and banking and thrift regulators
cannot agree on what to do in practice. (One thrift Franklin Savings, and its
regulator, the Office of Thrift Supervision, are in court in a disagreement over how
to interpret FASB Statement 80.)

Let’s look at some simple, non-judgmental standards that have been successful.
FASB Statement 14 on segments says that if 10 percent or more of total revenue is
from a segment, then data for the segment shall be reported separately. No ifs, ands,
or buts; 10 percent is 10 percent and FASB Statement 14 has been successful.
(Except that many users of financial statements would like segment reporting on a
quarterly basis, one seldom hears about problems with Statement 14. Could it be
that the success of a standard is measurable by the lack of complaint about it?) FASB
Statement 85 says that a convertible bond that has a cash yield of less than two-
thirds of the long-term corporate bond rate at the time of its issuance is a common
stock equivalent for the purpose of earnings per share computations. No ifs, ands,
or buts; two-thirds of that bond rate is easy to compute and that standard has been
successful. APB Opinion 15 says, in a footnote, that if the dilutive feature of a
convertible bond or preferred stock or option or warrant does not reduce earnings
per share by at least 3 percent, then fully diluted earnings per share need not be
reported. The 3 percent rule has been effective. It’s simple, and it works.

How might such a simple yet effective bright-line be applied to two live
recognition and measurement problems?

Lease accounting by lessees will never be right or correct insofar as all the
interested parties (lessees, CPAs, the SEC’s staff, and users of financial statements)
are concerned. FASB Statement 13, with all its amendments and interpretations, is
not the answer because only a few of us know how to apply Statement 13. (And
sometimes we don’t know what’s “right” until we ring up the SEC’s staff and check
with them.) We cannot explain the result. We need simple bright-line rules to fix
that problem, at least as to lessees. Either capitalize (recognize) all lease obligations or
none of them. If all leases are to be capitalized, specify the rate to be used to discount
the lessee’s contractual cash outflows: for example, use the 10-year US government
bond rate to discount the cash payments. That rate will not correspond exactly with
the lessee’s incremental borrowing rate, but there is no harm done by using that rate
as a surrogate for the lessee’s incremental borrowing rate—it’s only an estimate, not
perfection. We need not measure things to the sixth degree. The light is not worth
the cost of the candle. Users of financial statements will understand that approach;
it is easy to explain and understand.

Deferred tax accounting under FASB Statement 96 is incredibly complex, what
with scheduling and hypothetical tax-planning strategies for every temporary
difference in every taxing jurisdiction. If we must have deferred tax accounting, and
I question whether we should,2 why not just assume that all of the assets are sold for
cash at their book amounts and all of the liabilities are settled for cash at their book
amounts and the corporation files a final tax return on the day following the balance
sheet; the amount of tax payable or recoverable on that hypothetical final tax return

48 ACCOUNTING FOR ASSETS AND LIABILITIES

would be the deferred tax to be reported in the corporation’s balance sheet. Simple.
No scheduling. No hypothetical tax planning strategies. Under this approach, there
would be no debate about whether to discount the tax asset or liability; no
discounting would be necessary. Moreover, that simple answer could be explained to
and even understood by ordinary people. The results of APB Opinion 11 and FASB
Statement 96 cannot be explained and understood.

We could transport the idea of simplicity to the conceptual framework. Look at
the FASB’s definition of an asset and its characteristics:

25 Assets are probable18 future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events.

26 An asset has three essential characteristics: (a) it embodies a probable future
benefit that involves a capacity, singly or in combination with other assets, to
contribute directly to future net cash inflows, (b) a particular entity can obtain
the benefit and control others’ access to it, and (c) the transaction or other event
giving rise to the entity’s right to or control of the benefit has already occurred.
Assets commonly have other features that help identify them—for example assets
may be acquired at a cost,19 and they may be tangible, exchangeable, or legally
enforceable. However, those features are not essential characteristics of assets.
Their absence, by itself, is not sufficient to preclude an item’s qualifying as an
asset. That is, assets may be acquired without cost, they may be intangible, and
although not exchangeable they may be usable by the entity in producing or
distributing other goods or services. Similarly, although the ability of an entity
to obtain benefit from an asset and to control others’ access to it generally rests
on a foundation of legal rights, legal enforceability of a claim to the benefit is
not a prerequisite for a benefit to qualify as an asset if the entity has the ability
to obtain and control the benefit in other ways.

Egad! That is mind-boggling stuff. Most accountants do not understand it.
Ordinary people are mystified by it. We have not been able to solve accounting

18 “Probable” is used with its usual general meaning, rather than in a specific accounting or
technical sense (such as that in FASB Statement No. 5, Accounting for Contingencies., para.
3), and refers to that which can reasonably be expected or believed on the basis of available
evidence or logic but is neither certain nor proved (Webster’s New World Dictionary of the
American Language, 2nd college edn, New York Simon & Schuster, 1982, p. 1132). Its
inclusion in the definition is intended to acknowledge that business and other economic
activities occur in an environment characterized by uncertainty in which few outcomes are
certain (paras 44–8).

19 Cost is the sacrifice incurred in economic activities—that which is given up or forgone to
consume, to save, to exchange, to produce, and so forth. For example, the value of cash or
other resources given up (or the present value of an obligation incurred) in exchange for a
resource measures the cost of the resource acquired. Similarly, the expiration of future
benefits caused by using a resource in production is the cost of using it.

MARK TO MARKET ACCOUNTING 49

problems by using that definition. Almost any expenditure fits into that definition,
because it does not discriminate. We need a simple definition. How about defining
assets as CASH, contractual claims to CASH, and things that can be sold for CASH?3

Thatdefinition would do away with goodwill, pre-opening costs, employee training
costs, and other junk now called assets.4 The current definition is an abstraction.
Under that definition, the asset that I call a truck is not the FASB’s asset. The FASB’s
asset is the present value of the net cash flows that truck will produce by hauling coal
or lumber or steel, viz. the “probable future economic benefit.” I call it a truck.
Trucks can be sold for CASH. Abstractions—probable future economic benefits—
cannot be sold for CASH. Only real things can be sold for CASH. Only real things
can be assets. Mario Gabelli, John Neff, and Martin Zweig will understand and
appreciate that approach.5

Small and medium-sized companies will understand and appreciate that
approach. Many FASB standards are so complex that most small and medium-sized
companies do not have the staff to implement the standards. And they do not want
to pay their CPA firms to help to accumulate the information that is used only to
prepare financial statements but is not understood by or useful to the owners of the
company and their bankers. The Alliance of Practicing CPAs has called for a
“moratorium on new [FASB] standards” and/or a “separate, simplified set of
accounting standards for non public companies.”6 Small and medium-sized
companies and their CPA firms cannot afford to follow the FASB’s lead on complex
standards.

International standard setters also will not follow the FASB’s lead in issuing
complex, detailed standards. If the International Accounting Standards Committee
were to issue a standard as detailed as FASB Statement 96 on income taxes, the
IASC would lose its following, which is beginning to grow. That approach would be
not only foolhardy but also suicidal for the IASC.

Can you imagine a men’s shoe manufacturer in Lyon, France, who needs money
wanting to come to the United States to issue debt or equity securities or American
depository receipts? This French company has been preparing its financial
statements using French francs and the French language and French generally
accepted accounting principles and has a French auditor who practices only in
France. When the management of the French shoe manufacturer goes to issue
securities in the USA, it will learn that it must reconcile its net income and
shareholders’ equity to that which would result under US generally accepted
accounting principles. The management of the shoe manufacturer will learn that in
order to do that reconciliation both it and its auditor will have to learn the FASB’s
accounting pronouncements and those of its predecessors, the Emerging Issues Task
Force, and perhaps even the utterances of the Accounting Standards Executive
Committee of the American Institute of Certified Public Accountants. The
management of the French company will be dismayed and discouraged. The
management will say “We make shoes; we just want to raise a few dollars; we don’t
want to be fodder to be crushed by your accounting machines; we will go to Hong
Kong or Singapore or Geneva to raise money.” Repeat that for shoe makers in

50 ACCOUNTING FOR ASSETS AND LIABILITIES

Frankfurt, Osaka, Vancouver, and Edinburgh and you begin to see how stifling the
competition is here in the USA.

Accounting standards have to be implemented by ordinary people. Financial
reports are used by ordinary people. The standards and the results of applying the
standards have to be understandable to ordinary people. Beyond understandability
of new standards, the cost of change to a new standard and the cost of continued
compliance should not exceed the benefit. This cost-benefit test is a judgment call,
and my judgment is that we have to change the way we write standards. It’s perhaps
acceptable to have as an objective the construction of a Formula 1 racing machine,
and to state the objective of a standard in that fashion. But let’s remember some
practical constraints: automobiles for ordinary people are built on production lines,
not in high-tech hotrod garages. We drive our cars to work, school, and Friday
night softball games. The speed limit for us is 55/65mph on the highway, 30mph in
town, not 167 or 188 mph. Keep it simple.

If we keep it simple then the users of the information will have the information
that they can use. (What can users do with an intangible asset arising from
smoothing out pension expense except to ignore the asset?) The smaller CPA firms
and their clients will be able to keep up with the rest of the world. Preparers of
financial statements can stop fussing over things that cost a lot of money and have
little usefulness, like the “corridor” in pension accounting and scheduling temporary
differences for deferred income tax computations, and do things to improve the
quality of US products in the world marketplace. And the FASB will stand a better
chance of promoting its ideas in Australia, Canada, France, Germany, Great
Britain, Italy, Japan, Russia, Pacific Rim countries, and at the IASC.

Notes

1 I have heard it said at meetings of the Financial Standards Advisory Council, “Write
simple rules and leave it to the preparer and auditor of the financial statements to use
their judgement.” What happens under that approach is that the first time that a
preparer does not like its CPA’s answer, then a way will be found to take the question
to the Emerging Issues Task Force in an attempt to overturn the CPA’s answer.

2 I do not like hypothetical, as-if accounting. Deferred tax accounting is hypothetical,
as-if accounting.

3 This definition says nothing about how we might measure assets—cost or current
value. I think it ought to be current value, i.e., the price of the assets in a current sale
for CASH, at least for financial instruments.

4 We would have to fix FASB Statement 87 on pensions to do away with intangible
assets that arise under that statement. Deferred tax assets would disappear.

5 Mario Gabelli (Gabelli Asset Management Company), John Neff (Vanguard’s
Windsor Fund), and Martin Zweig (Zweig Fund) are investment portfolio managers.

6 Quote from the 30 November 1990 issue of Public Accounting Report.

MARK TO MARKET ACCOUNTING 51

5
What is an asset?

Accounting Horizons, Vol. 7, No. 3, September 1993

I am pleased to make my second appearance on the program of this annual national
conference on current SEC developments.

The year gone by has been one where the staff has concentrated on promoting
the commission’s drive for mark-to-market accounting for marketable debt and
equity securities. That policy was set out in congressional testimony in September
1990 by Chairman Breeden and in December 1990 by James Doty, the commission’s
former general counsel.

We have continued to encourage the Financial Accounting Standards Board, and
the financial community in general, to embrace the idea of mark to market for
marketable securities. Contrary to the perception by some, we have not been
promoting mark to market for other assets, such as plant and equipment, patents
and copyrights, or commercial loans held by banks. However, what the staff has
done is to suggest the idea that, when one is looking to identify impairment of the
carrying amount of assets such as stocks, bonds, loans, plant, and patents, it is
appropriate to look at the fair value of the asset and compare that fair value with the
carrying amount of the asset. And then, when one goes to measure impairment, fair
value of the asset would be the appropriate attribute to look at in order to obtain the
best and most relevant measure of the impairment. This approach is consistent with
the measurement of foreclosed assets and in substance foreclosed assets as
announced in Financial Reporting Release 28, issued in 1986. In that release, the
commission said that market value should be used to measure foreclosed assets and
in substance foreclosed assets, even in a situation where those market values come
from an auction market where assets are being bought for speculative purposes.

Also, during the past year, the staff has had discussions with numerous
registrants, mostly holding companies of financial institutions, regarding their
accounting for marketable debt securities. A good number of those registrants have
reclassified all or a portion of their bond holdings from the category of so-called
“long-term investments” accounted for at amortized cost to a category of “held for

sale” or “available for sale” accounted for at the lower of cost or market or, in the
case of certain insurance companies, at market These reclassifications were in
acknowledgment by registrants that their own actions indicated bonds they owned
were in fact not being held to maturity or for the long term. Those registrants also
revised their stated accounting policies to bring them into line with the registrants’
actual practices of buying and selling bonds, instead of buying and holding bonds to
maturity. I want to make the point here that the staff was enforcing,
administratively, the current literature based on cost and not market value; the staff
was not moving toward mark-to-market accounting by way of the back or side door
as has been suggested in some quarters.

[Schuetze referenced the FASB’s then pending projects on impairment and of
marketable securities, to be discussed at the conference by James Leisenring of the
FASB.]

What I would like to spend the balance of my remarks on is a more fundamental
issue, namely, the definition of an asset.

Last October, after the meeting of the World Congress of Accountants in
Washington, the FASB invited standard setters from around the world, and a few
other individuals, to meet at the FASB’s offices in Norwalk, Connecticut, for a day
and a half to share ideas about standard setting in various countries and at the
“international” level. During that conference, to which I was invited by the FASB, I
was taken by the lack of agreement on basic concepts about financial accounting
and reporting. One of those conceptual issues is the definition of an asset. It is clear
that one of the major roadblocks to resolving accounting issues here in the United
States is lack of agreement on the definition of an asset. As work on international
standards proceeds, that may be a problem as well.

So today I wish to offer, for the consideration of standard setters and others who
seek to improve the state of financial accounting and reporting, an alternative
definition of an asset. I suggest this alternative definition to be provocative and to
stimulate thought and discussion. I do not mean to imply that this is a definition
that the commission or its staff is proposing or will incorporate into its rules and
regulations or even impose in the day-to-day administration of the securities laws.

Most articulated definitions of an asset refer to “economic benefit” or “future
economic benefit” or “probable future economic benefit.” For example, the FASB’s
definition is “probable future economic benefit.” The full definition of assets from
the FASB’s Concepts Statement 3, which originally was issued in 1980 and which is
now included in Concepts Statement 6, is as follows:

Assets are probable future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events.

The FASB lists three essential characteristics of an asset, as follows:

(a) it [an asset] embodies a probable future benefit that involves a capacity,
singly or in combination with other assets, to contribute directly or indirectly

MARK TO MARKET ACCOUNTING 53

to future net cash inflows, (b) a particular entity can obtain the benefit and
control others’ access to it, and (c) the transaction or other event giving rise to
the entity’s right to or control of the benefit has already occurred.

The FASB goes on, in the same paragraph of Concepts Statement 6, to say:

Assets commonly have other features that help identify them—for example,
assets may be acquired at a cost and they may be tangible, exchangeable, or
legally enforceable. However, these features are not essential characteristics of
assets. Their absence, by itself, is not sufficient to preclude an item’s
qualifying as an asset. That is, assets may be acquired without cost, they may
be intangible, and although not exchangeable they may be usable by the entity
in producing or distributing other goods or services.

The FASB’s definition is so complex, so abstract, so open-ended, so all-inclusive,
and so vague that we cannot use it to solve problems. It does not require
exchangeability, and therefore it allows all expenditures to be considered for
inclusion as assets. The definition does not discriminate and help us to decide
whether something or anything is an asset. That definition describes an empty box.
A large empty box. A large empty box with sideboards. Almost everything or
anything can be fitted into it. Some even want to fit losses into the definition. When
I said in March 1992, as the SEC observer at the Emerging Issues Task Force, that
losses on “hedging” instruments related to anticipated transactions do not qualify as
assets under that definition, a lot of people objected to my conclusion, including
some members of the Emerging Issues Task Force. At the commission, we often see
proposals for the recognition as assets of operating losses of retail operations in the
start-up mode and operating losses of plants in their shakedown phase. The
definition seems large enough to some people to accommodate these losses.

We see situations at the commission, particularly in enforcement cases, where
there are long-winded briefs by registrants, their lawyers, their independent
auditors, and their expert witnesses quoting extensively from the FASB’s Concepts
Statement 6 to support a debit balance in the balance sheet as a fit and proper asset,
fully meeting the FASB’s definition of an asset. One sees even longer, long-winded
briefs in private, civil litigation. In that litigation, both sides, both the defendant
and the plaintiff, and all of their expert witnesses are citing the same passages from
the FASB’s Concepts Statement 6 in support of their positions regarding the
worthiness or unworthiness of a debit balance in a balance sheet as an asset. What
we have, then, in the lawyers’ words, are teams of swearing accountants—one
swearing “thus and so” and another swearing “such and that” – and they cannot resolve
what should be a simple question: whether something is an asset.

What generally happens in practice, under the FASB’s definition of an asset, is
that assets are not recognized unless the reporting enterprise acquires them by
paying cash or agreeing to pay cash in the future or someone contributes something
to the reporting enterprise in return for an ownership interest in the enterprise.

54 ACCOUNTING FOR ASSETS AND LIABILITIES

Then an asset is said to have a cost. In fact, we accountants sometimes think of the
asset and talk about it in terms of its cost, not in terms of the asset itself or the
future benefit that may flow from it. That is, the asset is the cost, or the cost is the
asset. For example, if an enterprise discovers something of value, say, oil or gold, we
do not recognize it as an asset because the enterprise has no cost. When the FASB
proposed several years ago that business enterprises recognize as assets things
received from others in a so-called non-reciprocal exchange, for example land
received from a government, some people objected. One of the reasons for the
objection was that the enterprise receiving the asset had no cost in the asset. I refer
to this phenomenon as the cost per se is the asset syndrome.

I will cite some examples:

• The AICPA’s Accounting Standards Executive Committee has outstanding an
exposure draft of a statement of position entitled “Reporting on advertising
costs” that says so-called direct-response advertising costs may be reported as
assets if the advertising activity resulted in probable future economic benefits.
Thus, the cost is the asset. In oil and gas accounting, either successful efforts as
described by the FASB in FASB Statement 19 or full cost as described by the
SEC in Regulation S-X, the asset represented in the balance sheet is the cost of
finding the oil and gas reserves, not the reserves themselves.

• In FASB Statement 60, the cost of acquiring insurance contracts is an asset.
• In AICPA Statement of Position 90–8, the cost of originating or acquiring

continuing care retirement community contracts is an asset.
• In FASB Statement 86, the asset is the cost of the computer software, not the

future benefit that will flow from the software.
• In the AICPA Accounting and Auditing Guide “Audits of casinos,” preopening

costs are assets.
• In the AICPA Accounting and Audit Guide “Audits of airlines” and the related

Statement of Position 88–1, costs of training flight crews and maintenance
crews, pre-revenue flight expenses, insurance, and the depreciation expense of
new aircraft are assets.

• In the AICPA Accounting and Audit Guide “Audits of government contractors,”
learning, start-up, or mobilization costs incurred for anticipated but unidentified
contracts are assets.

• In Accounting Principles Board Opinion 21, costs of raising debt finance are
assets.

• In FASB Statement 80, losses on future contracts related to anticipated but not
firmly committed transactions are assets.

• And, finally, in APB Opinion 16, the cost that is left over in a business combination
after the purchase price is allocated to all other assets and liabilities is an asset; it
is called cost of acquisition in excess of net assets acquired, or goodwill. Along
this same line, the International Accounting Standards Committee has proposed
that development costs, the “D” in R&D, may be recognized as an asset under
certain conditions.

MARK TO MARKET ACCOUNTING 55

In all of these cases, it is the cost itself that is identified as the asset, not a probable
future economic benefit. It is this same line of reasoning, that a cost can be an asset,
that leads some people to suggest that the FASB should reconsider FASB Statement
2 and allow for recognition of research and development costs as an asset. Note that
in none of the cases is the asset represented on the balance sheet exchangeable.

The cost of many assets does not represent anything close to the “probable future
economic benefit” to be derived from the asset. For example, the probable future
economic benefit of a successful, direct-response advertising campaign may be many
multiples of the cost. The future benefit of a discovery of mineral deposits generally
bears no relationship whatsoever to the costs of finding the deposits. The future
benefits of successful research and development also bear little or no relationship to
the costs incurred. The Concepts Statement 6 definition of an asset and the
historical cost model that we know and use today do not mesh.

Defining an asset as a probable future economic benefit is to use a high-order
abstraction. Under such an approach, if an enterprise owns a truck, the truck per se
is not the asset. The asset is the present value of the cash flows that will come from
using the truck to haul lumber, or coal, or bread. Yet, in today’s practice, the asset
represented on the balance sheet is a truck, and users of the financial statements see
it as a truck. The users do not see it as the economic benefit that will come from
using the truck to haul lumber. I think most people are more comfortable thinking
of the asset as a truck instead of as an abstraction, instead of the present value of
future cash flows or the economic benefit to be derived from it.

I suggest that we try an alternative definition. A simple one. One that is not a
large empty box. One that is not a high-level abstraction. I suggest that we try the
following definition: “Cash, contractual claims to cash or services, and items that
can be sold separately for cash.”

The suggested definition would comprehend only real things, not abstractions.
Real things such as trucks can be sold. Real things can be pledged as collateral. Real
things can be given to charity. Abstract probable future economic benefits cannot be
sold, pledged, or given away. The definition would not accommodate a cost as being
an asset. Losses would not fit into that definition. Exchangeability is a critical
element in that definition.

Let me list a few of the things this alternative definition would include.
Obviously, cash. Obviously, claims to cash such as trade receivables, loans
receivable, demand deposits at banks, certificates of deposit, cash surrender value of
life insurance policies, bills, notes, and bonds issued by governments, corporations,
partnerships, individuals, and trusts. Cash paid in advance for the future use of land
and buildings would be included. That definition would include raw materials,
finished goods, common stocks, land, buildings, equipment, mineral deposits, air
rights, water rights, landing slots at airports, broadcast rights, patents, and
copyrights. Work-in-progress inventory and fixed assets in the process of
construction would also be included, on the theory that they can be sold for cash
when completed.

56 ACCOUNTING FOR ASSETS AND LIABILITIES

Let me list what would be excluded: any cost as such, such as pre-opening costs.
Proportions of assets that arise in proportional consolidation, such as 33 percent of
cash or accounts receivable or plant held by a joint venture in which venture the
reporting enterprise has a one-third interest would be excluded. (However, the one-
third interest in the joint venture itself would be an asset.) Receivables sold with
recourse and thus owned by another enterprise would be excluded. Assets leased by
lessees would be excluded for the same reason. So would deferred taxes. Goodwill
would be excluded because it cannot be sold apart from the business.

I submit that use of that alternative definition would vastly simplify the practice
of accounting. Intuitively, I think it would appeal to investors and other users of
financial statements. I note, in that regard, that the Association of Investment
Management and Research has recently recommended that the cost of goodwill no
longer be recognized as an asset. Intuitively, I think the alternative definition would
appeal to ordinary men and women who walk up and down Main Street, USA, and
those who walk up and down Main Street in other countries. They would
understand it. I think that ordinary people who are not accountants think that when
they see an asset in a balance sheet the asset is something real, and that it represents
value; that is, if it is not cash or a claim to cash, that it can be sold separately for
cash. Accounting should not be done for the benefit of accountants. Accounting
should result in financial statements that ordinary people will understand and
therefore be able to use to make investment and credit decisions.

Accountants would also understand that alternative definition. They could use it
to identify things to be reported as assets on balance sheets. They could use it to
identify, through exclusion, things not to be reported as assets on balance sheets.
We would dispense with all of the long-winded briefs about the fitness of debit
balances as assets and the teams of swearing accountants. Assets would be real
things, exchangeable things. Defining assets as real things would also tend to make
balance sheets less prone to challenge and thereby reduce litigation against
registrants and auditors. It would tend to make balance sheets rock solid. As this
audience knows well, auditing the recoverability of a cost, or the impairment of a
cost, is hard enough when the cost is associated with a real thing where one can look
to the market value of the real thing to test for impairment. Auditing the
recoverability or impairment of something that is just a cost, a cost not associated
with a real thing, is more than hard.

Another benefit to be gained would be improved comparability in financial
accounting and reporting. In practice, many of the costs recognized as assets are not
recognized as assets by all enterprises. Some enterprises, motivated by income tax
considerations or conservatism, or for other reasons, charge to income such costs
when incurred, whereas other enterprises recognize the cost as an asset. Thus, in
practice, there is a significant degree of non-comparability in financial accounting
and reporting with respect to such costs or such assets. Where non-comparability is
most evident, because of the size of the amounts, is in the accounting for the cost of
goodwill. The cost of goodwill must be reported as an asset by enterprises domiciled
in the USA and reporting under US generally accepted accounting principles but

MARK TO MARKET ACCOUNTING 57

may be charged to shareholders’ equity or “reserves” by enterprises domiciled in
other countries and not reporting under US generally accepted accounting
principles.

Using that alternative definition of an asset of course would not govern or suggest
which attribute of the asset ought to be or could be selected for recognition and
measurement and reporting on the face of the balance sheet. The acquisition price,
or historical cost, could be used for non-monetary operating assets. Or historical
cost updated for changes in the general price level. Or the current cost of similar
productive capacity. Or the present value of future cash flows. Or the estimated
selling price of the non-monetary asset As to financial instruments such as
marketable stocks and bonds, the acquisition price or current market value could be
used, and I would, of course, suggest market value. Or one could be eclectic and
select from the menu of attributes of assets to be recognized and measure that
attribute which is judged to provide the most relevant information possible for
decision making by investors and creditors, limited of course by cost-benefit
constraints.

The definition of an asset that is in use today is too inclusive, overly complex, and
vague. I suggest that standard setters take another look at the definition.

58 ACCOUNTING FOR ASSETS AND LIABILITIES

6
What are assets and liabilities?

Where is true north? (Accounting that my sister would
understand)

Abacus, February 2001

This is an article about what I think financial accounting and reporting
ought to look like—about my vision that the singular focus of financial
accounting and reporting should be on cash, that is, cash itself,
contractual claims to cash, things (assets) that can be converted into
cash, and obligations to pay cash, and that assets and liabilities should be
stated at fair value in corporate balance sheets. I call this formulation
“true north.”

I have previously written about how we should keep financial
accounting and reporting simple (“Walter Schuetze on keep it simple,”
Accounting Horizons, June 1991, pp. 113–17). I have also written about
how assets should be defined for accounting purposes (“What is an
asset?” Accounting Horizons, September 1993, pp. 66–70). This article
builds on those two earlier ones. It deals with definitions of assets and
liabilities that should be recognized (that is, displayed, shown, or
reported) in corporate balance sheets and how the recognized assets and
liabilities should be measured when reported in those balance sheets.

Key words: accounting; fair value; measurement; simplicity.
The rules for financial accounting and reporting in the USA have become vastly too
voluminous, too detailed, too complex, and too abstruse. At this writing in July
2000, the Financial Accounting Standards Board has issued 139 statements on
financial accounting standards (SFASs). Public companies in the USA, and foreign
companies whose securities are listed in the USA, must follow these standards in the
preparation of their financial statements or in the reconciliation of their home-
country financial statements to US standards. Because some of those 139 superseded
a prior standard, the count of currently effective standards is about 100. In addition
to standards, there is previously issued literature inherited by the FASB at its

formation in 1973 from the American Institute of Certified Public Accountants,
namely Accounting Research Bulletins and Accounting Principles Board Opinions.
This legacy literature has the standing and authority of a standard. The FASB itself
has also issued numerous interpretations of standards and has issued technical
bulletins prepared by the FASB’s staff.

The FASB’s staff has also issued numerous special reports dealing with various
accounting matters dealt with in standards, for example A Guide to Implementation
of Statement 125 on Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, and guidance for implementation of SFAS 133,
Accounting for Derivative Instruments and Hedging Activities. The FASB’s Emerging
Issues Task Force has issued several hundred “consensuses,” each dealing in extreme
detail with quite specific accounting problems. (The issues summaries for the July
2000 meeting of the task force run to more than 300 typewritten pages, many of
which are single spaced.)

The American Institute of Certified Public Accountants has issued numerous audit
and accounting guides, statements of position, and practice bulletins, most of which
have been vetted by the FASB and its staff prior to the issuance of those documents
by the AICPA. The AICPA has also issued technical practice aids, which are not
vetted by the FASB or its staff prior to issuance.

As well, the Securities and Exchange Commission and its staff have issued
numerous rules, regulations, releases, and bulletins dealing with financial accounting
and reporting.

All of this literature constitutes generally accepted accounting principles, which is
required accounting by public companies in the USA. As well, the large public
accounting firms have issued their own guidance or interpretation or “how to”
guides that instruct the firms’ partners and staff on various FASB, AICPA, and SEC
pronouncements. These firm-prepared documents often run to hundreds of pages.
For example, shortly after the FASB issued Statement 133, Accounting for Derivative
Instruments and Hedging Activities, in June 1998, itself more than 200 pages in
length, several accounting firms issued their own guidance on how to apply
Statement 133—which guidance constituted more than 400 pages in the case of one
firm and 500 pages in the case of another. I have all of these documents in my
office, but many are on the floor because my bookcase is full. And all of this is
before mentioning standards issued by the International Accounting Standards
Committee since its inception in 1973.

The volume and complexity of those pronouncements have become overwhelming
—on a par with the Internal Revenue Code and the related regulations in the USA.
The volume and complexity have become too, too much for (1) those insiders who
are responsible for and prepare financial statements and reports, (2) those outsiders
who audit those financial statements and reports, (3) those outsiders such as
investors, creditors, underwriters, boards of directors and audit committees, and
analysts who use those financial statements and reports, and (4) those outsiders who
regulate the preparation, audit, and dissemination of financial statements and
reports.

60 MARK TO MARKET ACCOUNTING

The hapless user of the financial statements and reports has almost no grip on the
rules governing financial reporting and thus, in many cases, does not understand the
financial statements and reports. Indeed, in a survey of 140 star sell-side analysts,
Epstein and Palepu (1999) found that “Footnotes [where asset and liability
recognition and measurement are described] seem to frustrate analysts the most.
When asked which components of the annual report they often have a hard time
understanding and which they would like explained more, star analysts rated the
footnotes first. Thirty-five percent of the analysts have difficulty understanding the
footnotes, and 55 percent would like further explanation of the footnotes.” Imagine
that. Star, sell-side analysts do not understand the accounting. Buy-side analysts
(institutions) cannot be any better equipped to understand the accounting. Is it any
wonder that the London School of Business advertises a financial seminar for senior
managers that enables senior managers to “decode published financial statements”
(The Economist, 14 November 1998, p. 101)?

Financial analysts are not alone. I was chief accountant to the SEC (January 1992
to March 1995) and chief accountant of the SEC’s Division of Enforcement (mid-
November 1997 to mid-February 2000). While on the staff of the commission, I
tried to explain relatively simple accounting issues and accounting rules to the
commission’s legal staff and its litigators, FBI agents, US postal inspectors, and
assistant US attorneys in the Department of Justice so that they could bring and
prosecute civil and criminal cases before administrative law judges, Federal judges,
and juries. I had minimal success even on simple issues. The litigators and
prosecutors are very reluctant to bring accounting fraud cases unless smoking guns are
evident, such as, for example, fake invoices, boxes filled with bricks instead of laptop
computers, or incriminating memos.

Financial accounting and reporting should be based on intuition, not
inculcation. There really should be nothing complicated about it. It is not like
medicine. It is not like the law. It is not rocket science. Ordinary people, chief
executive officers, line operating managers, members of boards of directors,
investors and creditors and regulators, who are not accountants, should be able to
look at financial statements and reports and understand the information portrayed
and conveyed. After all, it is the non-accountants who use financial statements and
reports to make investment, credit, and regulatory oversight decisions, not to
mention corporate governance decisions. But ask members of boards of directors,
members of audit committees of boards of directors, members of the investing and
credit-granting public, financial analysts, and members of regulatory oversight
bodies to explain, in plain English, the meaning of the representations in the
financial statements and reports they use to make decisions and there is no response.
I repeat—there is no response. They must turn to the accountant to furnish the
explanation. The accountant’s explanation turns out to be not in plain English at all
but in arcane jargon understandable only by other accountants, and not necessarily
all other accountants but only the initiated ones. The much proclaimed
transparency in corporate financial accounting and reporting in the USA is in fact a
considerable illusion insofar as the numbers (dollar amounts) in the financial

ACCOUNTING FOR ASSETS AND LIABILITIES 61

statements and reports are concerned. The numbers are not very transparent at all.
Only accountants know how the numbers are derived, and sometimes only a very
few accountants.

I say again, preparation of financial statements and reports, their use, and their
regulation should be based on intuition, not inculcation. The way it is now,
however, to be fully conversant with all of the financial accounting and reporting
requirements means that one has to live in a medieval, unheated, stone building in
the Pyrenees, wear a brown robe with a rope belt, a skull cap, and clogs, and
memorize accounting literature (dogma). I recently received a mailing from
the AICPA advertising a two-day course on accounting for business combinations at
a price of $1,295 or at $1,035 for AICPA members. Can you believe that? Two
days and over a thousand dollars to learn about one accounting problem.

There are more than 330,000 CPAs in the USA. No more than a few hundred of
them know the workings of the standards on (1) leases, (2) foreign currency
translation, (3) pensions, (4) post-retirement benefits other than pensions, (5)
interest (whether and when to capitalize interest cost), (6) deferred income taxes, (7)
investments in debt securities, (8) impairments of carrying amounts of loans
receivable or long-lived operating assets, (9) transfers and servicing of financial assets
and extinguishments of liabilities, and (10) derivative instruments and hedging
activities. Moreover, each one of these areas has such detailed, complex, and
abstruse rules that the few hundred CPAs who are expert in accounting for
derivatives often are not the same few hundred CPAs who are expert in accounting
for pensions. Each monk knows just one book of the Bible.

I liken the use of financial statements and reports to driving an automobile.
Automobiles are powered by internal combustion engines, but drivers of autos do
not need to know anything about what makes the auto go except that gasoline (or
petrol) is necessary and that the engine oil needs to be replaced occasionally. That is
virtually all that I know about my auto. Comparing accounting to the auto, one
needs to be the equivalent of a mechanical engineer to use and drive the auto called
financial accounting and reporting. We accountants are doing accounting for
accountants’ sake, not for use by investors, creditors, under-writers, analysts, boards
of directors, and regulators, who are the people that we accountants should aim to
please.

How overwhelming today’s accounting is can be demonstrated by the response to
a proposal for improving the effectiveness of audit committees. The Blue Ribbon
Committee on Improving the Effectiveness of Corporate Audit Committees, co-
chaired by John Whitehead and Ira Millstein, in one of its ten recommendations
about improving the effectiveness of audit committees, recommended that the audit
committee, in the annual report to shareholders, attest that audit committee
members believe, based on discussions with management and the external auditor,
that the financial statement conforms to generally accepted accounting principles
(see Recommendation 9 of the Report and Recommendations of the Blue Ribbon
Committee on Improving the Effectiveness of Corporate Audit Committees, issued in
1999). That recommendation was soundly rejected by commentators in financial

62 MARK TO MARKET ACCOUNTING

and legal circles. In response to a reporter, the general counsel of the Securities and
Exchange Commission said that “The reference to generally accepted accounting
principles has created some fear and confusion because audit committee members
have been concerned that they don’t know the intricacies of the accounting rules.
Audit committees understand accurate, full and fair disclosure, and that things may
not be materially misleading, but they don’t necessarily understand the nuances of
generally accepted accounting principles” (Wall Street Journal, 14 July 1999, p.
C14). The SEC, in its new rule on audit committees, did not require that the audit
committee give the opinion suggested by the Blue Ribbon Committee. Instead, the
SEC amended its rule to require only that the audit committee publicly state that it
had reviewed and discussed the audited financial statements with the auditor and
that the audit committee recommends the inclusion of the audited financial
statements in the form 10-K or 10-KSB. (SEC Release 34.42266, 22 December
1999.) The new rule does not require the audit committee to give an opinion about
compliance with generally accepted accounting principles. In my opinion, most
members of audit committees, if not virtually all members of audit committees,
could not give the opinion suggested by the Blue Ribbon Committee, because the
accounting is beyond their ken. Incidentally, I think it is a fair question to ask: how
can boards of directors and audit committees satisfy their governance responsibilities
if they do not understand the accounting numbers?

I use my sister as a guidepost when I think about accounting issues. She has no
university education. She runs a successful small business located near my home
town of Comfort, Texas. She prepares financial statements for her business to run
her business and so that the other owners of the business may see how well the
business has done under her leadership. In the financial statements of her business,
assets are cash, contractual claims to cash, and things that the business owns and that
can be sold for cash—all at fair value, that is, the amount of cash any of the non-
cash assets would fetch in an immediate sale for cash less cost to sell the asset. When
she consults me about the preparation of the financial statements for her business
and I try to explain to her the standards that we accountants use to prepare financial
statements, her eyes glaze and she blames my accountababble on my having sat for
too long in the hot Texas sun. She recently bought out one of her competitors and
paid about $100,000 in excess of the fair value of the identifiable net assets acquired.
The competitor agreed not to compete against my sister’s business for five years. I told
her that the $100,000 represented the cost of the non-compete agreement and
purchased goodwill, which, under generally accepted accounting principles, should
be reported as assets. She laughed at me. Try to pay salaries, rent, the electric, or
dividends with those assets, she said. That kind of accounting may be okay for Wall
Street but not for Main Street in Comfort, Texas. Moreover, she said, those so-
called assets will not earn a penny. The $100,000 is gone—irretrievably gone. It is
spent money. Whether her business earns any additional net after-tax cash flows as a
result of buying out her competitor and getting him to agree not to compete with
her business for five years will be decided by the former competitor’s customers—
whether they decide to patronize her business and buy her business’s services. She

ACCOUNTING FOR ASSETS AND LIABILITIES 63

does not control what those potential customers may do. Not an asset today, she says.
Maybe tomorrow, if and when those customers buy her business’s services and
generate additional after-tax cash for her business. Not a fit and proper asset to be
recognized in advance of sales to customers, however. In short, in accounting
parlance, the $100,000 is a quintessential “gain contingency” that should not be
recognized as an asset until it materializes in the form of cash.

Moreover, there is no overarching theme to this huge body of literature governing
financial statements and reports to which the uninitiated, or even the initiated, may
refer. The FASB says that the information in financial statements and reports has to
have “decision usefulness.” But the numbers in balance sheets for reported assets and
liabilities are the result of mechanically applying all of the rules and literature
described above without regard to whether the result is understood by and makes
sense to the people who actually use it. Remember my reference earlier to the
findings of Epstein and Palepu about star, sell-side analysts who do not understand
the notes to the financial statements. As a guide or standard, “decision usefulness” is
so non-specific and allows so much judgment and leeway that it is not helpful.
What we need instead is a definition of true north in accounting. Everyone knows
where north lies on a compass, and we can navigate towards it in our daily journeys
in accounting. Decision usefulness, on the other hand, can lie anywhere on the
compass.

Under the current rules, in addition to cash, we have the following as to assets
representing contractual claims to cash:

1 Receivables, generally at the amount of cash expected to be collected and
generally not reduced for the time value of money or otherwise reduced to fair
value. This category includes such items as trade receivables, amounts due to
the reporting enterprise by a counterparty under a currency or interest rate
swap agreement, insurance premiums due from the owner of an insurance
policy, income tax refunds, and amounts due from vendors/suppliers under
cooperative advertising agreements. Amounts of receivables not yet billed are
included in this category. For example, companies that perform construction
work for the US government often show “unbilled receivables” as assets on
their balance sheets.

2 Loans receivable having fixed or determinable amounts. Examples are
commercial or residential mortgage loans and loans made by banks and insurance
companies to individuals as a result of the individuals’ using credit cards to buy
goods and services, to small businesses, and to large commercial customers, at
the present value of the amount of cash expected to be collected based on the
effective interest rate in the loan. If the carrying amount of a loan is deemed
not to be collectible in full, then the carrying amount of the loan is reduced to
(a) the fair value of any collateral, (b) the market price of a similar loan if such a
price exists, or (c) the revised expected cash flows reduced for the time value of
money using the interest rate implicit in the loan at its inception. (The cost of

64 MARK TO MARKET ACCOUNTING

originating loans is added to the “cost” [cash advanced to the borrower] of the
loans.)

3 Securities representing an interest in indeterminate cash flows from “securitized”
loans receivable, at the fair value of the security, with changes in that fair value
being recognized (a) in income by traders such as broker/dealers and some
banks and (b) in shareholders’ equity (net assets) by other holders such as banks
if the security is classified as “available for sale.” Classification of such a security
as “held to maturity” by the owner would have the security being reported at
historical cost. These kinds of securities arise in transactions where the
originator of loans, such as mortgage loans and automobile loans, sells tranches
of the loan portfolio to investors such as insurance companies, mutual funds,
and trusts administered by banks.

4 Securities representing contractual, fixed or determinable cash flows, such as
bonds, based on fair value or historical cost of the security.

5 Refundable cash deposits, such as the portion of an insurance premium that
would be recaptured if the policy were to be cancelled.

As to assets such as inventory, land, plant, equipment, and patents (sometimes called
non-monetary items) that are not cash and claims to cash, we have the following:

6 The amount of cash paid, at some time in the past, for an item other than cash
or a claim to cash plus related expenditure, which is called “historical cost.” For
example, the amount of cash paid for land plus brokers’ fees, legal fees, appraisal
fees, documentary fees, and other fees applicable to the acquisition of the land.
These fees could be material in relation to the cash price paid for the land.
Other examples include amounts of cash paid for such things as plant,
equipment, copyrights, patents, and TV or radio broadcasting rights. The
amount of cash paid—the cost—is reduced by periodic charges made to
income so as to allocate the cost to periodic income on what is said to be a
rational and systematic basis.

7 The portion of a lump-sum purchase price paid for two or more assets acquired
together, as, for example, in a business combination, that is allocated to one of
the assets acquired, which amount would generally be the fair value of the asset.
For example, the amount of cost allocated to land acquired in a business
combination would be the fair value of the land but would not include the
various fees described in 6 above.

8 The fair value of an asset at the time it was received by the reporting enterprise
in return for the issuance of a debt or equity instrument, also said to be
“historical cost” of the asset: for example, the fair value of land contributed to
the reporting enterprise in exchange for stock. However, if the land is
contributed to the reporting enterprise by a promoter or controlling
shareholder, then the cost to the reporting enterprise is not the fair value of the
land but instead is the historical cost of the land to the contributor (an SEC

ACCOUNTING FOR ASSETS AND LIABILITIES 65

rule). (Note that the “historical cost” of land under 6, 7, or 8 could be three
different, possibly materially different, amounts for the same parcel of land.)

9 Net realizable value, the amount of proceeds expected on sale of an asset such
as work in progress or finished goods less cost to complete and cost to sell.

10 Current market prices in the case of certain equity securities but not others,
such as when the owner of the equity security is said to have significant
influence but not control of the investee, in which case the so-called equity
method of accounting is required (see 11).

11 Historical cost of certain equity securities plus the arithmetic share of the
investee’s earnings and other changes in the investee’s net assets said to be
attributable to the investor (accounting by formula).

12 Fair value of assets at the date of the write-down of the carrying amount of
those assets whose carrying amount was deemed to be impaired, which carrying
amount after the write-down is then said to be “new historical cost.”

13 Fair value of exchange-traded and over-the-counter derivative contracts having
a positive value.

14 Deferred income taxes, which are solely the result of computations done only
by accountants, reduced, in some cases, by an allowance, the need for and
amount of which is determined solely by management based on its judgment.

15 Valuation allowances for certain assets; some allowances involving discounting,
such as allowances for losses on individual loans where the discount rate is the
rate of interest inherent in the loan when it was originated; and some allowances
involving no discounting, such as allowances for deferred tax assets and
allowances for loan losses that are said to relate to portfolios of loans instead of
individual loans. The amounts of these allowances are determined solely by
management based on its judgment.

16 The amount of cash paid for certain services to be received in the future such as
advertising (prepaid advertising), placement of a manufacturer’s product on
shelves in grocery stores (slotting fees), and cash advances to writers for books
or movies to be written or scripted, at the amount of cash paid reduced by
periodic charges made to income to allocate to income the amount paid on
what is said to be a rational and systematic basis.

17 The right, perhaps through a so-called barter exchange or by use of barter
credits issued by a barter exchange, to buy goods or services at a price less than
the posted price or rack price. Examples are advertising space, radio or TV time,
or hotel “nights.” Such rights also arise when vendors agree that customers
may, based on the volume of their prior purchases, buy goods or services in the
future at a discount from the posted price. (Do you have credits for airline
miles that you have earned that you can use for upgrades to first class or for free
tickets?) Some people believe that such a right or credit is a future economic
benefit that should be recognized as an asset. Let me illustrate with an example.
Suppose I buy groceries from the nearby supermarket. The bill is $42.00.
When the cashier checks me out and gives me my receipt, the cashier also gives
me a coupon that allows me to buy a bottle of 100 aspirin tablets at $5.75

66 MARK TO MARKET ACCOUNTING

instead of the shelf price of $6.75. The price reduction of a purchase in the
future of a bottle of aspirin tablets at $5.75 instead of $6.75 is, in the minds of
some, a future economic benefit that should be recognized as an asset under
today’s generally accepted accounting principles—recognized as an asset by
allocating a portion of the $42 to the “value” of the coupon, I suppose. I am not
making this up. But that is the kind of goofy answer that one can get under
today’s accounting for “future economic benefits” (more on “future economic
benefits” later). My sister would shake her head in disbelief.

18 The amount of cash paid for certain things that only accountants call assets: for
example, the cost incurred by banks to originate loans receivable, the cost
incurred by insurers to originate certain types of insurance policy, the cost of so-
called direct-response advertising, interest cost, and finally, the cost of
purchased goodwill. (At this writing, some commentators are urging the FASB
to rescind FASB Statement 2 [and Interpretation 4 thereof], which requires
that the cost of R&D be charged to expense when incurred; those
commentators would have corporations recognize as an asset some or all of its
R&D expenditure.)

19 Some items that are solely the result of computations done only by
accountants, such as amounts produced by applying the standards related to
pensions and deferred income taxes.

As to liabilities, under the current rules, some amounts are:

1 What is to be paid in cash to vendors (accounts payable), to employees (wages
payable), to counterparties under derivative contracts, to owners (dividends
declared and payable), to taxing authorities, sometimes based on tax returns as
filed and sometimes based on what management of the enterprise says will be
the final tax payable after negotiation or litigation with taxing authorities.

2 Proceeds of borrowings.
3 Refundable cash collected from customers in advance of delivery of goods or

services to those customers.
4 Deferred or unearned revenue, which is an amount representing cash collected

from a counterparty in return for services to be rendered, reduced by credits to
earned revenue that are determined based on services rendered or on what is
said to be a systematic and rational basis.

5 Mandatory redeemable stocks generally measured at the redemption amount
(an SEC rule, not a standards rule).

6 A calculated amount for promises to repair or replace faulty products.
7 Fair value of exchange-traded and over-the-counter derivative contracts having

a negative value.
8 Deferred income taxes, which are based solely on computations done only by

accountants.

ACCOUNTING FOR ASSETS AND LIABILITIES 67

9 Whatever management of the reporting enterprise says will be a cash outflow in
the future in respect of non-contractual bonuses to employees, “restructurings,”
plant closures, or similar events.

10 A calculated amount for pensions and post-retirement benefits other than
pensions.

The preceding discussion about various assets and liabilities assumes that the US
dollar is the unit of measurement in the financial statement. If the unit of
measurement is not the US dollar but a foreign currency, then another complexity
is added in that the foreign currency amounts, determined using US generally
accepted accounting principles, would be “translated” into US dollars using the
current exchange rate. This procedure produces different “historical cost” amounts
for identical assets if there has been a change in exchange rates between the time the
assets were acquired and the date of the balance sheet; for example, three identical
IBM computers, bought at the same time for the same price and located in different
countries, say Canada, Mexico and the USA, would be shown at three different
historical cost amounts in the balance sheet.

Then, because all of these amounts are expressed in Arabic numbers, we add them
up as if they were cut from the same bolt of cloth and call them “total assets” and
“total liabilities.” And reporting services such as Moody’s, Standard & Poor, and
Value Line and analysts and investors compute and use things like return on assets
and return on equity based on this potpourri of numbers.

What a cacophony! What the user of the financial statement hears is nothing but
noise. It is as if each musician in the orchestra is playing from his or her self-selected
sheet of music, one of the Three Tenors is singing in Italian, the second in German
and the third in French, all without a conductor.

How did all of this happen? Well, its origin lies mainly in the fact that the staff of
the SEC, in its early days (and lately as well), would not accept write-ups of assets to
fair value and did not require write-downs to fair value except in extreme cases,
because it thought the fair value numbers were too soft. Because we accountants
were told by the SEC that we could not put current fair values in balance sheets but
instead had to use historical cost, we accountants set about trying to make income
the right number. Since the 1930s, when our federal securities laws were enacted,
we have been trying to recognize, measure, and present income as opposed to assets
and liabilities or net assets. In trying to get the right income number, we often put
debits and credits on the balance sheet so as not to “distort” income. So as to time
the recognition of these debits and credits in income when it is thought to be
“right” or based on management’s intent. It is as if the balance sheet is a holding pen
for expenditure to be released to expense sometime in the future when the time is
right. (Visualize a pen full of sheep awaiting their turn to be sheared.) We defer
costs on the balance sheet and try to attach them or match them with revenue or
allocate them to income on a causal basis or what is said to be a systematic and
rational basis. We use different inventory costing methods: average cost; first in, first
out; and last in, first out. A reporting enterprise may use almost any inventory

68 MARK TO MARKET ACCOUNTING

costing method except what is called “base stock.” On occasion, we see companies
changing from one acceptable inventory cost method to another. Methods of
calculating depreciation, depletion, and amortization expense run from accelerated
methods to straight line to units of production. We often see changes in method.
Estimated useful lives and salvage values or end values of the same kinds of fixed
asset can vary significantly from company to company. Whether the carrying
amounts of fixed assets are impaired is a judgment by management, for it is
management that estimates the future cash flows from the asset in making the
assessment about impairment None of these deferrals, allocations, estimates of
future cash flows, or formula-driven amounts can be verified or authenticated by
reference to an actual phenomenon in the marketplace.

Most of this accounting is, in the end, highly judgmental. This accounting is
what I call “feel-good” accounting. The AICPA’s Committee on Accounting
Procedure (1939–59) promulgated accounting rules designed to get income to be
the correct number through feel-good accounting. That is, we like the financial
statement results even though we may not be able to articulate why the results are
what they are except by referring to the manner in which the amounts were
determined. The accounting results, in many cases, cannot be audited or verified or
authenticated by reference to any evidential matter coming from an outside source,
but somehow we feel good about the numbers. An extreme example of feel-good
accounting is from the Committee on Accounting Procedure in chapter 10 of
Accounting Research Bulletin No. 43, Taxes: Section A, Real and Personal Property
Taxes, paragraphs 10–13, which reads as follows:

10 In practice, real and personal property taxes have been charged against the
income of various periods, as indicated below:

a Year in which paid (cash basis),
b Year ending on assessment (or lien) date,
c Year beginning on assessment (or lien) date,
d Calendar or fiscal year of taxpayer prior to assessment (or lien) date,
e Calendar or fiscal year of taxpayer including assessment (or lien) date,
f Calendar or fiscal year of taxpayer prior to payment date,
g Fiscal year of governing body levying the tax,
h Year appearing on tax bill.

11 Some of these periods may coincide, as when the fiscal year of the taxing
body and that of the taxpayer are the same. The charge to income is
sometimes made in full at one time, sometimes rateably on a monthly basis,
sometimes on the basis of prior estimates, adjusted during or after the period.

12 The various periods mentioned represent varying degrees of
conservatism in accrual accounting. Some justification may be found for each
usage, but all the circumstances relating to a particular tax must be considered
before a satisfactory conclusion is reached.

ACCOUNTING FOR ASSETS AND LIABILITIES 69

13 Consistency of application from year to year is the important
consideration and selection of any of the periods mentioned is a matter for
individual judgment.

The best way to sum up all of those alternatives of how to account for property
taxes is to say that the accounting is whatever makes us feel good.

The AICPA’s Accounting Principles Board (1959–73) also issued feel-good
accounting rules; witness pooling-of-interest accounting and amortization of the cost
of purchased goodwill over forty years. To a large extent, the FASB is doing the
same; witness gains and losses on derivative contracts not being entered into earnings
until the time is right; witness deferred gains and losses under pension accounting;
witness the manner in which the carrying amount of fixed assets is to be assessed for
impairment by reference to management’s estimate of future cash flows from the
asset instead of the fair value of the asset; witness the judgmental nature by which
valuation allowances for loans receivable and deferred income tax assets are
determined. Feel-good accounting rules can be set only by and through a political
process; that is, who has the most votes or who can shout the loudest. Feel-good
accounting produces numbers for non-cash assets and liabilities that are the result of
keeping income smooth or steady, or better yet, steadily increasing, but smoothly. To
take what otherwise would be variable, lumpy earnings and smooth those earnings.
(Visualize a huge yellow Caterpillar bulldozer pushing the hills of economic change
into the valleys of economic change.)

The FASB has been in business since 1973. It said, in its Concepts Statement 3,
issued in 1980, that it “expects most assets and liabilities in present practice to
continue to qualify under the definition [in Concepts Statement 3].” These words
were carried forward by the FASB in Concepts Statement 6 issued in 1985 (paras
170, 177). The board in Concepts Statements 3 and 6 thus blessed—and poured
into concrete—what was practice in the early to mid-1980s, which practice
continues in large measure today in 2000 in the USA. Unless the FASB changes its
conceptual framework, or unless the FASB itself is changed, there will not be much
movement away from feel-good accounting. The question arises: is it time to start
thinking about changing the FASB?

Today, most articulated definitions of an asset refer to “economic benefit” or
“future economic benefit” or “probable future economic benefit.” For example, the
FASB’s definition is “probable future economic benefit.” The full definition of
assets from the FASB’s Concepts Statement 3, which was originally issued in 1980
and which is now included in paragraph 25 of Concepts Statement 6, is as follows:
“Assets are probable future economic benefits obtained or controlled by a particular
entity as a result of past transactions or events.” In paragraph 26 of Concepts
Statement 6, the FASB lists three essential characteristics of an asset, as follows: “(a)
it [an asset] embodies a probable future benefit that involves a capacity, singly or in
combination with other assets, to contribute directly or indirectly to future net cash
inflows, (b) a particular entity can obtain the benefit and control others’ access to it,
and (c) the transaction or other event giving rise to the entity’s right to or control of

70 MARK TO MARKET ACCOUNTING

the benefit has already occurred.” The FASB goes on, in the same paragraph, to say:
“Assets commonly have other features that help identify them, for example, assets may
be acquired at a cost and they may be tangible, exchangeable, or legally enforceable.
However, these features are not essential characteristics of assets. Their absence, by
itself, is not sufficient to preclude an item’s qualifying as an asset. That is, assets may
be acquired without cost, they may be intangible, and although not exchangeable
they may be usable by the entity in producing or distributing other goods or
services.” That is mind-boggling stuff! I can tell you from experience that most
accountants that I know do not understand the FASB’s definition of assets.
Ordinary folk—investors, creditors, analysts, underwriters, CEOs, line managers,
members of boards of directors and audit committees, journalists, judges, and juries
—are mystified by that babble. (That is one reason why I no longer tell people at
dinner parties that I am an accountant. When I did, they appeared to feel sorry for
me, averted their eyes, and silently hoped that the hostess had seated all the
accountants together at one table away from the other folk.)

The FASB’s definition of an asset is so complex, so abstract, so open-ended, so
all-inclusive, and so vague that we cannot use it to solve problems. It does not
require exchangeability of that which is called an asset; therefore it allows all
expenditures to be considered for inclusion as assets. The definition does not
discriminate and help us to decide whether something or anything on the margin is
an asset. That definition describes an empty box. A large empty box. A large empty
box with sideboards. Almost everything or anything can be fitted into it. The FASB,
in its 7 September 1999 exposure draft of Accounting for Business Combinations and
Intangible Assets, is even proposing to put the cost of purchased goodwill into that
box. The five FASB members who assented to the publication of that exposure draft
believe that the cost of goodwill is an asset. The two dissenters, who dissent for
reasons unrelated to the initial accounting for the cost of purchased goodwill at the
date of the business combination, in obiter dicta, say that they too think that the
cost of purchased goodwill is an asset. A very large box indeed!

I have seen numerous situations at the SEC, particularly in litigated enforcement
cases, where there are long-winded briefs by issuer-registrants, their independent
auditors, and their expert witnesses, quoting extensively from the FASB’s Concepts
Statement 6 to support a debit balance in the balance sheet as a fit and proper asset,
fully meeting the FASB’s definition of an asset. One sees similar long-winded briefs
in private, civil litigation. In that litigation, both sides, both the defendant and the
plaintiff, and all of their expert witnesses, are citing the very same passages from the
FASB’s Concepts Statement 6 in support of their positions regarding the worthiness
or unworthiness of a debit balance in a balance sheet as an asset. What we have,
then, in the lawyers’ words, are teams of swearing accountants—one swearing “thus
and so” and another swearing “such and that,” both invoking the same words in the
same literature—and they cannot resolve what should be a simple question: whether
something is an asset.

What generally happens in practice under the FASB’s definition of an asset is that
assets are not recognized in the balance sheet unless the reporting enterprise acquires

ACCOUNTING FOR ASSETS AND LIABILITIES 71

them by paying cash or agreeing to pay cash in the future, or someone contributes
something to the reporting enterprise in return for a debt or equity security issued
by the enterprise. An asset is then said to have a cost. In fact, accountants sometimes
think of the asset and talk about it in terms of its cost, not in terms of the asset itself
or the future benefit that may flow from it. That is, the asset is the cost, and the cost
is the asset. For example, if an enterprise discovers something of value, say, oil or
gold, we do not recognize it as an asset, because the enterprise has no cost in that
something. When the FASB proposed some time ago that business enterprises
recognize as assets things received from others in a so-called non-reciprocal
exchange, for example, land received from a government, some accountants
objected. One of the reasons for the objection was that the enterprise receiving the
asset had no cost in the asset. I refer to this phenomenon as the cost per se is the
asset syndrome.

I will cite some examples of costs equal assets. (I am aware that the FASB has said
in paragraph 179 of Concepts Statement 6 that costs are not themselves assets. In
my experience, however, most preparers and auditors of financial statements
continue to equate costs with assets in their conversations and in the way they
prepare and audit financial statements. After all, the FASB said in Concepts
Statements 3 and 6 that then “present practice” would continue, and in that
practice costs equal assets.) The AICPA’s Accounting Standards Executive
Committee, without objection from the FASB, issued a statement of position
entitled Reporting on Advertising Costs, which says that so-called direct-response
advertising costs are to be reported as assets if the advertising activity results in
probable future economic benefits. Thus, the cost is the asset. In oil and gas
accounting, either successful efforts as described by the FASB in Statement 19 or
full cost as described by the SEC in Regulation S-X, the asset represented in the
balance sheet is the cost of finding the oil and gas reserves, not the value of the
reserves themselves at the time of discovery or any time thereafter. In FASB
Statement 34, interest cost is an asset. In FASB Statement 60, the cost of issuing
insurance contracts is an asset. In FASB Statement 86, the asset is the cost of
developing computer software, not the future benefit that will flow from the
software. In Accounting Principles Board Opinion 21, the cost of raising debt
finance is an asset, a “deferred charge.” And, finally, in APB Opinion 16 and in the
FASB’s September 1999 exposure draft dealing with Accounting for Business
Combinations and Intangible Assets, the cost that is left over in a business
combination after the purchase price is allocated to the identifiable assets and
liabilities is an asset; it is called cost of acquisition in excess of the fair value of net
assets acquired, or cost of purchased goodwill. (In a letter dated 15 June 2000 to the
FASB commenting on the FASB’s September 1999 exposure draft of Accounting for
Business Combinations and Intangible Assets, I called it a glob.) Along this same line,
the International Accounting Standards Committee says that development costs, the
D in R&D, may be recognized as an asset under certain conditions. In all of these
cases, it is the cost itself that is identified as the asset, not the probable future
economic benefit. It is this same line of reasoning, that a cost can be an asset, that

72 MARK TO MARKET ACCOUNTING

leads some people to suggest that the FASB should reconsider FASB Statement 2
and allow for recognition of research and development costs as an asset.

Generally, when assets are acquired for cash, the fair value of the assets acquired,
or the future economic benefit, is approximately equal to the cash paid (laying aside
the difference between bid and ask prices and costs of actually buying assets, such as
brokers’ fees). So, at least at the date of acquisition of the asset, cost equals fair value
and future economic benefit. (We all know that, soon after the acquisition of an
asset, say, land, cost and fair value begin to diverge and often become quite far
apart.) The cost of many assets recognized under the FASB’s definition does not, at
the time of acquisition, represent anything close to the “probable future economic
benefit” to be derived from the asset. For example, the probable future economic
benefit of a successful direct-response advertising campaign may be many multiples
of the cost. The cost of prepaid advertising or direct-response advertising only by
chance will be equal to the present value of increased net cash flows that may result
because of the advertising. The future economic benefit of a discovery of mineral
deposits generally bears no relationship whatsoever to the cost of finding the
deposits. The future economic benefits of a successful research and development
project also bear little or no relationship to the cost incurred.

Defining an asset as a probable future economic benefit is to use a high-order
abstraction. Under such an approach, if an enterprise owns a truck, the truck per se
is not the asset. The asset is the future economic benefit, that is, the present value of
the cash flows that will come from using the truck to haul lumber, or coal, or bread.
Yet, in today’s practice, the asset represented on the balance sheet is a truck. Readers
of the financial statements see the asset as a truck. The readers do not see it as the
economic benefit that will come from using the truck to haul lumber. I think most
people, even most accountants, think of the asset as a truck instead of an abstraction,
instead of the present value of future cash flows, or the future economic benefit, to
be derived from using the truck to haul lumber.

I think that we should account for real things such as trucks, not abstract future
economic benefits. I suggest that we adopt a different definition of an asset. A
simple one. One that is not a large empty box. One that is not a high-order
abstraction. I suggest that we adopt the following definition: “cash, contractual
claims to cash, things that can be exchanged for cash, and derivative contracts
having a positive value to the holder thereof.”

My definition would comprehend only real things, not abstractions. Real things
such as trucks can be sold for cash. Real things can be pledged as collateral for a
borrowing of cash. Real things can be given to charity. Exchange-traded derivative
contracts having a positive value can be closed out for cash. The positive value of an
over-the-counter derivative contract can be turned into cash by entering into an
equal and offsetting contract. Abstract probable future economic benefits cannot be
sold, pledged, or given to charity. My definition would not accept a cost as being an
asset. A critical feature in my definition is exchangeability of the asset, which is
explicitly not a feature of the FASB’s definition of an asset (see FASB Concepts
Statement 6, para. 26).

ACCOUNTING FOR ASSETS AND LIABILITIES 73

Let me list a few of the things that my definition would include. Obviously, cash.
Obviously, claims to cash such as trade receivables, loans receivable, demand
deposits at banks, certificates of deposit, cash surrender value of life insurance
policies, bills, notes, and bonds issued by governments, corporations, partnerships,
individuals, and trusts. Cash paid in advance for the future use of land and
buildings would be included as an asset if the cash could be recaptured from the
lessor by the lessee at its option. That definition would include raw materials,
finished goods, common stocks issued by other enterprises, land, buildings,
equipment, mineral deposits, air rights, water rights, broadcast rights, patents, and
copyrights.

Work-in-progress inventory and fixed assets in the process of construction might
be included if they can be sold for cash in their present condition or state. Growing
crops would be excluded, because a crop generally cannot be sold separately from
the land, but the value of the growing crop would increase the fair value of the land,
which can be sold. Also included would be futures, forward, option, swap, and
swaption contracts having a positive value; exchange-traded derivative contracts can
be closed out with the receipt of cash, and over-the-counter derivative contracts can
be offset with equal and opposite contracts, thereby producing cash.

Let me list some of the things that would be excluded: any cost as such, such as
pre-opening costs, debt issue costs, interest cost, and advertising cost. Costs of
opening new stores or branches. Employee training costs. Costs of restructuring a
business. Assets that arise in proportional consolidation, such as 33 percent of cash
or accounts receivable or plant held by a joint venture in which venture the
reporting enterprise has a one-third interest would be excluded. (However, the one-
third interest in the joint venture itself would be an asset.) Receivables sold with or
without recourse and thus owned and controlled by another enterprise would be
excluded, because the receivables were sold and are not owned by the seller and
cannot be sold again by the seller. Assets owned by others and leased by the reporting
enterprise would be excluded for the same reason unless the lease itself was
transferable either directly or through a sublease and had a positive value. “Prepaid
advertising” would be excluded unless the advertiser could get back its money at its
option or could sell the advertising space, say, a billboard or an appearance on
someone else’s website. Costs of R&D or only D would not be an asset. Nor would
so-called deferred tax assets be assets. Cost of purchased goodwill, or any other
goodwill, would be excluded. It is significant to note, in this regard, that the
Association for Investment Management and Research, which represents stock
analysts in the USA, has recommended that the cost of purchased goodwill not be
recognized as an asset (see Financial Reporting in the 1990s and Beyond, Association
for Investment Management and Research, 1993, pp. 48, 49; and AIMR’s letter to
the FASB dated 7 December 1999, which is AIMR’s response to the FASB’s
exposure draft of Accounting for Business Combinations and Intangible Assets).

The use of my definition of an asset would vastly simplify the practice of
accounting. Vastly simplify financial accounting and reporting. I believe that
it would appeal to investors, creditors, and other users of financial statements. I think

74 MARK TO MARKET ACCOUNTING

the results of applying my definition would appeal to ordinary men and women
who walk up and down Main Street in the USA, and those who walk up and down
Main Street in other countries as well. They would understand the result. My sister
would understand the result. I think that ordinary people who are not accountants
think that when they see an asset on a balance sheet that the asset is something real,
and that the dollar amount associated with the asset represents value, that is, that
the asset can be exchanged for cash for approximately the dollar amount at which the
asset is represented in the balance sheet. That the asset can be pledged as collateral
for a borrowing. That the asset may be given to the Red Cross. Accounting should
not be done for the benefit of accountants. Accounting should result in financial
statements and reports that ordinary people can understand and therefore be able to
use to make investment and credit decisions and regulatory oversight decisions.

Accountants could use my definition as a working tool. They could use it to
identify things to be reported as assets on balance sheets. They could use it to
identify, through exclusion, things not to be reported as assets on balance sheets,
which is not possible today. We would dispense with all of the long-winded legal
briefs about the fitness of debit balances as assets and the teams of swearing
accountants. Assets would be real things. Exchangeable things. Defining assets as
real things, and reporting those real things at their fair value, would make balance
sheets rock solid and less prone to challenge and thereby reduce litigation against
companies and their auditors. Would make balance sheets relevant, living
documents instead of what they are now—dimly lit basement parking garages for
collections of antique costs. Assessing and auditing the recoverability or impairment
of something that is just a cost, a cost not associated with a real thing, is more than
hard. It’s impossible. One cannot look to the marketplace and find the value of a
cost. All that the auditor can do is look at numbers that management puts on a
sheet of paper or a computer monitor about how management believes that cost will
be recovered. That’s not gathering competent, evidential matter. That’s not
auditing. If an auditor is allowed to accept management’s assertion about the value
of that which is reported as an asset instead of having to find competent, evidential
matter from sources outside the reporting enterprise to support that value, then
audits have no purpose or worth. Scrap audits and save the cost of audits.

I repeat, the definition of an asset that is in use today is too inclusive, overly
complex, and vague. It does not work. I suggest that standard setters take another
look at the definition and include the feature of exchangeability.

The FASB’s definition of a liability suffers from a similar infirmity to its
definition of an asset. The FASB says in Concepts Statement 6, paragraph 35, that
“Liabilities are probable future sacrifices of economic benefits arising from present
obligations of a particular entity to transfer assets or provide services to other
entities in the future as a result of past transactions or events,” Footnote 22 expands
on those words in the definition as follows:

Obligations in the definition is broader than legal obligations. It is used with
its usual general meaning to refer to duties imposed legally or socially; to that

ACCOUNTING FOR ASSETS AND LIABILITIES 75

which one is bound to do by contract, promise, moral responsibility, and so
forth (Webster’s New World Dictionary, p. 981). It includes equitable and
constructive obligations as well as legal obligations.

paras 37–40.

Most people know what a legal obligation is. But most people do not know what an
equitable or constructive obligation is, or what an obligation arising from moral
responsibility is. Even the FASB does not know, for it has not articulated what those
obligations are and what their characteristics are so that we can recognize them
when we see them. Therefore, every time the FASB wants to require some
accounting because of what it sees as an equitable or constructive obligation, or
what an obligation arising from a moral responsibility is, the FASB has to write a
detailed rule for accountants to use in drawing up financial statements. Look, for
example, at our accounting in the USA for workers’ pension benefits. Long before
any benefit is vested in the employee, the FASB instructs us to recognize a pension
liability. The idea is that the workers are earning the pension benefit over time, and
a liability for an equitable or constructive obligation should be recognized prior to
vesting of the benefits. But only the FASB knows what that equitable or
constructive obligation is, how it is defined, when it should be recognized, and how
it should be measured. The ensuing liability number, computed as per the FASB’s
formula, cannot be audited or verified except by checking the calculation, which is
no audit at all. A perfect example of feel-good accounting.

Yet another example of feel-good accounting is a recent phenomenon in the
USA, dating from the late 1980s and early 1990s. That is the accounting for so-
called restructurings. The FASB’s Emerging Issues Task Force, in Consensuses 94–3
and 95–3, said that it is okay to recognize a liability to pay termination bonuses or
stay bonuses to workers that will be discharged before the workers’ rights to that
bonus are vested. EITF 94–3 and 95–3 are the ultimate in feel-good accounting.
Management of the enterprise recognizes a liability if it says that it will make future
expenditures, although there is no requirement for those expenditures to be made;
in fact those expenditures may be avoided at will. The rationale is that management
creates, by its proclamation to make the expenditures, a constructive or equitable
obligation. If management does not make a proclamation about future expenditures
for termination bonuses or stay bonuses but simply lays off workers and pays the
workers termination bonuses in the ordinary course of business, then there
apparently is no constructive or equitable obligation in advance of the cash
disbursement to the terminated employee. I wonder how loud management’s
proclamation must be in order to create an accounting liability.

The FASB’s definition of a liability is as infirm as its definition of an asset. We
cannot solve the question, at the margin, of what is and what is not a liability, because
the definition is so open-ended.

I suggest that we define liabilities by reference to future cash outflows required by
negotiable instruments, by contracts, by law or regulation, by courtentered judgments
or agreements with claimants, and derivative contracts having a negative value.

76 MARK TO MARKET ACCOUNTING

I think that a liability recognizable for accounting purposes should be one of the
following:

1 A future cash outflow required by a negotiable instrument, such as a recourse
promissory note, issued by the reporting enterprise, and accrued interest
thereon. (The unpaid amount of a non-recourse note secured only by a specific
asset would be netted against the fair value of the asset, for it is only the net
amount of cash that the owner could get on sale of the asset. If the amount of
unpaid debt exceeds the fair value of the asset, there is no liability to report,
because the future cash outflows related to the debt may be avoided at will by
walking away from an asset having a net value of zero.)

2 A future cash outflow required by the terms of a contract under which the
counterparty has completed his/her/its obligations. Examples are (a) accounts
payable to suppliers of goods, which goods have been delivered to and accepted
by the reporting enterprise, (b) accounts payable to suppliers of services where
the counterparty has performed according to the terms of the contract, (c)
salaries and wages for work done by employees, (d) deposit accounts of banks
and thrifts, (e) death benefits payable to beneficiaries under life insurance
policies as a result of the insured’s death (not an actuarially determined amount
but the actual amount payable to the owner’s estate or other beneficiaries), (f)
vested pension benefits as to working and retired employees in excess of the fair
value of any pension plan assets held by trustees, which assets may be used to
pay only pension benefits, (g) amounts payable to counterparties under
derivative contracts, (h) outstanding stock of the reporting enterprise, which
stock must, by its terms, be redeemed for cash by the reporting enterprise
(mandatorily redeemable stock), and (i) future “dividends” on issued and
outstanding stock that unconditionally must be paid in cash by the reporting
enterprise, including cumulative dividends on so-called perpetual preferred
stock.

3 A future cash outflow required by a contract at the option of the counterparty.
Examples are (a) sales returns by customers, (b) warranties related to defective
product (in which case the cash outflow may be for parts and labor to fix the
product), (c) cash surrender value of life insurance contracts issued (not an
actuarially determined amount but the actual amount refundable to owners of
the policies at the owners’ requests), (d) refundable portion of magazine
subscriptions, (e) refundable portion of fire, flood, and other casualty insurance
premiums, (f) refundable portion of cash collected in advance from a counter-
party prior to the reporting enterprise’s having delivered goods or services to
the counterparty, as to which amount the counterparty would have an
enforceable claim if the reporting enterprise fails to deliver the goods or services,
and (g) claims payable to insureds under various kinds of insurance policies.

4 A future cash outflow required by a federal, state, or local law or regulation.
Examples are (a) amounts withheld from employees’ salaries to be remitted to a
governmental body by the reporting enterprise, (b) sales tax, valueadded tax, or

ACCOUNTING FOR ASSETS AND LIABILITIES 77

similar tax collected by the reporting enterprise from its customers to be
remitted to a governmental body by the reporting enterprise, (c) tax based on
taxable income or taxable capital of the reporting enterprise (the amount is to be
determined by reference to the tax return filed or to be filed, not some greater
or lesser amount to take into account contestable or negotiable matters), (d)
decommissioning of nuclear plants, and (e) remediation of contaminated water
or ground.

5 A future cash outflow that would be required on default or rescission of an
executory contract that is unperformed as to both counterparties. Examples of
executory contracts are those for the use of property (leases) and those to
acquire property (inventory purchases).

6 Derivative contracts (futures, forwards, options, swaps, and swaptions) having a
negative value over and above the amount of cash currently payable, which is
included in 2 (g) above.

7 A future cash outflow required by a court-entered judgment or an agreement
with a claimant. An example is a future cash outflow to an employee or an
outsider as a result of a claim relating to a bodily injury.

Under the above definition of a recognizable liability, a proclamation by
management that it intends to make certain future cash disbursements, no matter
how loud that proclamation, would not qualify as a recognizable liability. For
example, a proclaimed intention to pay year-end cash bonuses to employees would
not be a recognizable liability if management may change its mind and not pay the
bonuses and if no law or regulation requires that the bonuses be paid. An
announced intention to pay termination bonuses, or stay bonuses, to employees
who eventually may be terminated pursuant to a “restructuring” also would not be a
recognizable liability if no contract or law or regulation requires the enterprise to
terminate the employees and pay the termination bonuses. An announced intention
to spend more money than is required by law to remediate contaminated ground
would not be a recognizable liability, for the expenditure may be avoided at will
without penalty.

No “reserve” or “valuation allowance” or “provision” of any kind would be a
recognizable liability or an offset to any asset amount. Journalists, judges, and other
ordinary folk think that “reserves” or “provisions” are vessels containing green
money. This is evident from reading the Wall Street Journal, The New York Times,
legal briefs, and court opinions. We need to get rid of the terms “reserves” and
“provisions.”

Computed amounts would not be recognizable liabilities under the definition, for
example, deferred tax liabilities, actuarially determined amounts of pension benefits
to be paid to working and retired employees, and actuarially determined amounts
payable to owners of life insurance policies or the beneficiaries of those policies.

As I define assets to be recognized in balance sheets, they are the reporting
enterprise’s cash, claims to cash, and other things that are owned by the reporting
enterprise and are exchangeable for cash. As I define liabilities to be recognized in

78 MARK TO MARKET ACCOUNTING

balance sheets, they are the reporting enterprise’s future cash outflows. All
recognized assets and liabilities would be reported at fair value. True north.

“Fair value,” of course, needs to be defined. The FASB’s definition of the fair
value of an asset is as follows, from paragraph 7 of FASB Statement 121: “The fair
value of an asset is the amount at which the asset could be bought or sold in a
current transaction between willing parties, that is, other than a forced or
liquidation sale.” (The definition of fair value for a financial instrument in FASB
Statement 107 is, except for a minor difference of wording, the same.) That
definition does not work very well. Owners of assets often contend that they would
not be willing sellers at the prices offered by potential buyers. Owners also often
contend that, because of lack of liquidity, “abnormal” market conditions, whatever
abnormal is, or for other reasons, prices being offered by potential buyers are for
“forced” or “liquidation” sales. Those matters are so judgmental that the FASB’s
definition does not work at the margin. I have seen it not work in enforcement cases
at the SEC, where respondents will not write down the carrying amount of assets
because they say the prices being bid are for forced or liquidation sales and that the
respondents would not be willing sellers at those prices. So the standard does not
work.

I would define fair value of assets as follows: the estimated amount of cash the
asset would fetch in an immediate sale whether or not under duress, without
recourse or guarantees, less the estimated amount of cash that would have to be paid
out to accomplish the sale. This suggested definition is clear and permits no
judgments about the state of the market or the willingness of the seller to sell at
prices being offered or bid by potential buyers.

I would define the fair value of liabilities as follows: the least amount of cash that
the counterparty would accept in an immediate and complete liquidation of his/her/
its claim against the reporting enterprise.

Let me list a few of the beneficial effects that adoption of my proposal would
have.

1 Users of financial statements and reports would understand the line-item
descriptions and numbers in the balance sheet, namely, what the reporting
enterprise owns and what it owes, with all measurements based on immediate
cash prices. True north. There would be no balance sheet deferrals followed by
(arbitrary) allocations of those deferred amounts to future periods. There would
be no need for pages and pages of footnotes that describe the recondite procedures
used to calculate amounts in financial statements, as is now the case. However,
there would need to be disclosures about the assumptions made in estimating
the fair value of assets and liabilities so that users of the financial statements
would be fully informed.

2 Financial accounting and reporting under my approach (a) would be vastly
simpler than what we have today and (b) would be understood by investors,
creditors, underwriters, CEOs, line operating managers, analysts, journalists,
editors, lawyers, judges, US senators and representatives, and ordinary folk.

ACCOUNTING FOR ASSETS AND LIABILITIES 79

Members of boards of directors and audit committees would understand the
line-item descriptions and numbers in the balance sheet. Corporate governance
would take a quantum stride forward.

3 Fraud in audited financial statements would virtually cease to exist, because
opportunities for cooking the books would no longer be available. Auditors
would be responsible, as they are today, for auditing cash and other
transactions involving assets (as defined herein). Auditors would confirm with
banks the amount of cash on deposit. Auditors would confirm with
counterparties the amounts owed to the enterprise. Auditors would confirm
payables with counterparties. Auditors would observe inventory counts.
Auditors would go to outsiders to get opinions regarding what the outsiders
believe are the fair values of the enterprise’s individual, exchangeable assets.
Auditors would go to outsiders to get opinions about the fair value of the
enterprise’s liabilities. Auditors could not accept management’s opinion about
the fair value of assets or liabilities unless that opinion was corroborated by
outsiders. In other words, auditors would get competent evidence supporting
management’s assertions in the balance sheet. That’s what auditing should be
about. For an exhaustive discussion of what auditing should be about, I
commend to all Peter Wolnizer’s book Auditing as Independent Authentication
(1987).

We in the USA have seen many frauds that were perpetrated by so-called improper
revenue recognition. We have labored to try to write rules for when and in what
amount revenue may be recognized. We have lots of rules telling us when revenue
may be recognized and how to measure it. The latest iteration is the SEC’s Staff
Accounting Bulletin 101, issued 3 December 1999. But, looking at revenue
recognition as being the problem is to look down the wrong end of the pipe. Every
line item and every amount in the income statement (or in a statement of changes in
net assets as I would have in my scheme of things) is fathered in the balance sheet.
There is no sales transaction to report until the enterprise receives cash or a promise
by the counterparty to pay cash. Auditors should look at the balance sheet. That’s
where the DNA is. Auditors should ask a commercial bank or a factor what amount
of cash it would pay, without recourse or guarantees, for the receivable arising from
the sale. If the bank or factor says 100 or 95 or 84 or 39 or zero, then report the
receivable, and therefore the sale, at that amount. Then disclose the name of the
bank or factor that gave the opinion so that users of the financial statement will
know who gave the opinion. Under my scheme of things, fraudulent financial
reporting because of improper revenue recognition would disappear.

4 The FASB could stop writing complex accounting rules, which no one except
accountants understand, and not very many accountants at that. The FASB, or
some other body, would have to develop standardized valuation techniques for
use by reporting enterprises and outside valuation experts when estimating the
cash sale price of an asset if there is no liquid market for that kind of asset.

80 MARK TO MARKET ACCOUNTING

Guidance would be necessary to estimate the cash sale price of many fixed
assets, for example a railroad between Massachusetts and Florida, a
petrochemical plant in Texas, a shoe factory in Brazil, a semiconductor
manufacturing facility in Taiwan, or a salmon farm in Scotland.

Nowadays, we have amounts in balance sheets for fixed assets that are just numbers;
the numbers have no information content whatsoever. Depreciation methods and
salvage values are (almost) whatever management wants them to be. Whether the
carrying amount for those fixed assets is impaired is determined by reference to all
of the future, undiscounted cash flows attributable to the assets—cash flows
projected by management as far as the eye can see. What an irrelevant methodology.

Let’s assume that a company owns a fleet of commercial aircraft having a cost of
100. The value of aircraft declines to 80 because the price of fuel goes up, but the
owner of the aircraft cannot put through increases in the price of tickets sold to
passengers. Under the current standard in the USA, so long as all future net cash
flows related to the aircraft, projected as far as the eye can see, without reduction for
risk and the time value of money, equal or exceed 100 no write-down is made to
reduce the carrying amount of the aircraft to 80. I used as an example a fleet of
aircraft because we can learn the going price of aircraft fairly easily and at little cost.
The concept is the same for any asset as to which there are not readily available price
quotations, such as a railroad or a petrochemical plant or a shoe factory or a
computer chip manufacturing plant or a salmon farm. (I would point out that there
are many kinds of asset as to which the fair values can be obtained from outside
parties at a relatively small cost considering the information value of those fair value
amounts. Examples are land-, air-, and ocean-going transportation equipment,
pipelines, office buildings, apartment buildings, shopping malls, warehouses,
mineral reserves, and maybe even satellites.)

FASB Statement 15, Accounting by Debtors and Creditors for Troubled Debt
Restructurings, was issued in 1977. Before being amended by FASB Statement 114,
Statement 15 said that the total of all future cash inflows related to a receivable were
to be compared with the carrying amount of the receivable to measure any loss on
the receivable. So long as the undiscounted future cash inflows, no matter how
distant, equalled or exceeded the carrying amount of the receivable, no loss was to
be recognized. Never mind that the fair value of the receivable or the underlying
collateral might be far less than its carrying amount. Statement 15, issued in 1977,
retarded the thinking of an entire generation of accountants and significantly
increased the US government’s losses in the S&L mess in the 1980s because losses
kept growing, and piling up on balance sheets, but were not recognized as such in
income statements under Statement 15 until the federal government took over the
assets. US taxpayers then took the hit in the S&L bailout. Although the FASB
somewhat, but not completely, fixed the loan-loss measurement problem in FASB
Statement 114, Accounting by Creditors for Impairment of a Loan, issued in 1993, the
board then repeated the same mistake in 1995 when it issued Statement 121,
Accounting for Impairment of Long-Lived Assets to be Disposed Of. Statement 121 says

ACCOUNTING FOR ASSETS AND LIABILITIES 81

to look to the total of future cash inflows from long-lived assets, no matter how
distant, compare that undiscounted amount with the carrying amount, and
recognize no loss unless the total cash inflows are less than the carrying amount,
even though the fair value of the asset might be significantly less than the carrying
amount The thinking of yet another generation of accountants is being retarded
now under Statement 121.

5 The debate over purchase versus pooling accounting would disappear. With all
assets (as defined herein) and liabilities (as defined herein) being reported as
such in the balance sheet, and all at fair value, every business combination
would be reported by combining the assets and liabilities of each party to the
business combination-all at fair value. No debate about who acquired whom. No
debate about whether the cost of purchased goodwill is an asset.

6 The debate over accounting for stock options issued to employees would not
exist. No cash or other asset goes out of the enterprise, and no obligation to pay
cash arises when a stock option is granted or exercised, so there is no decrease in
assets or net assets and therefore nothing to account for except for the cash
received when the option is exercised. When the attention is on cash inflows
and cash outflows and changes in the fair values of real assets and liabilities, as
it is in my proposal, it is clear that the issuance of stock options to employees,
and exercise of those options, is a rearrangement of the ownership interest
between the various owners and potential owners, not a decrease in corporate
assets. The value of what one owner relinquishes to a potential new owner or a
new owner is not imputed to the reporting enterprise. The reporting enterprise
accounts for its assets and changes in them, not its owners’ assets.

7 Earnings management would disappear as an issue. In the USA, I have seen
earnings being managed almost at will by chief executive officers and chief
financial officers. Loading accrued liabilities or “reserves” in good times and
drawing them down in lean times. Or drawing down reserves or estimated
liabilities, such as for warranties, whenever it is necessary to “make the
numbers.” Changing assumptions so as to time the recognition of write-downs
of the cost of long-lived assets instead of when the value actually declined.
Projecting net cash inflows, or increasing net cash inflows, as far as the eye can
see to justify not writing down the cost of long-lived assets. Earnings
management is a scourge in the USA. Earnings management is the ultimate in
accounting gimmickry. By participating in this gimmickry, accountants not
only have cheapened their image but also have raised serious questions about the
substance of what they do.

8 We could stop arguing with banks about the size of their allowances for loan
losses. Whether such allowances may be recognized only for loans that are
already bad or for loans that may go bad as well. The loans would be reported at
their fair value, which comprehends all credit risk. I know that we will need
guidance from the FASB, or some similar body, on how to estimate those fair
values, but at least then we would be trying to get a relevant number that can

82 MARK TO MARKET ACCOUNTING

be audited by reference to an outside source instead of an allowance that is
determined judgmentally by management, as it is today.

9 We would no longer be arguing with banks and insurance companies about
whether their bond holdings are for trading, held for sale (not trading), or held
to maturity, with each of the three approaches producing a different income
number. Going through these convoluted discussions gives accounting and
accountants a bad name. Ordinary folk think that we accountants are
practicing a dark art.

10 Huge gains and losses, mostly losses, on sale or discontinuance of assets would
disappear. Users of financial statements today have a hard time interpreting
how these gains and losses should be factored into previously reported income
from an analytical standpoint. Changes in fair value of assets would be
recognized as changes take place, not on sale or discontinuance.

11 It is now in vogue in the USA for the directors to discuss with the outside
auditor what the auditor thinks about the “quality” of the company’s
accounting (see Recommendation 9 of the Report and Recommendations of the
Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit
Committees, issued in 1999, and the AICPA’s Practice Alert 2000–2, dated
February 2000, entitled Quality of Accounting Principles—Guidance for
Discussions with Audit Committees). That dialogue would not be necessary
under my proposal. The basis of every company’s financial statements would be
the same as every other company’s: what the company owns and what it owes,
with the fair values of those things being determined by reference to facts or
opinions received from outsiders instead of being based on a management-
determined number. True north.

12 Students who aspire to be accountants could learn financial accounting and
reporting in a very short time. As it is now in the USA, students must have five
years of university study to become certified public accountants. Although I
taught a few staff training courses when I was in public practice, I have no training
on how to teach. However, I venture that I could teach students in one year,
maybe less, how to do financial accounting and reporting my way. Thus,
graduating students would not be so deeply in debt on student loans as they are
today when they graduate.

Estimating cash selling prices for assets for which there is no ready market would be
the largest challenge in implementing my proposal. We cannot look up prices for
most assets in business publications. We would need guidance from the FASB, or
some similar body, on how to estimate those prices. The FASB will soon face that
issue if and when it requires that all financial instruments be reported at fair value.
Developing that guidance no doubt would give rise to debates about how to
estimate those prices. What kinds of model to use in estimating those prices. What
the inputs to the models should be. However, that debate would be about
something that would be important and relevant for making investment and credit
decisions. Currently, the debates that the FASB has with its constituencies about

ACCOUNTING FOR ASSETS AND LIABILITIES 83

when to report and how to measure various assets and liabilities are not debates but
are (shouting) arguments about whether a particular expenditure is an asset or an
expense and recondite procedures to be used to compute financial statement
amounts, for example pension liabilities and deferred taxes. The only reason that the
FASB wins these arguments is a political one, to wit, the SEC requires that public
companies in the USA follow the FASB’s rules. Resolution of such debates should
turn on relevance of information, logic, merit and substance, not political clout.

My accounting would be simple. It would have a simple, singular focus-cash. All
assets and liabilities would be stated at fair value. We all would know where north
lies on that accounting compass. The results of the accounting could be audited or
verified or authenticated by auditors by reference to facts and opinions about the
fair values of assets and liabilities—facts and opinions obtained from people outside
the reporting enterprise. Real auditing. Investors, creditors, underwriters, analysts,
CEOs, line managers, members of boards of directors and audit committees,
lawyers, judges, regulators, journalists, editors, US senators and representatives, and
ordinary people would understand that accounting. My sister would understand it.

References

AICPA Practice Alert (2000) Quality of Accounting Principles—Guidance for Discussions With
Audit Committees, AICPA, 2 February 2000.

Association for Investment Management and Research (1993) Financial Reporting in the
1990s and Beyond, AIMR.

Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees
(1999) Report and Recommendation of the Blue Ribbon Committee on Improving the
Effectiveness of Corporate Audit Committees, available on www.nvse.com.

Committee on Accounting Procedure (1953) Taxes: Section A, Real and Personal Property
Taxes, Accounting Research Bulletin No. 43.

Epstein, M.J. and Palepu, K.G. (1999) Strategic Finance, Institute of Management
Accountants.

Schuetze, W.P. (1991) “Walter Schuetze on keep it simple,” Accounting Horizons.
Schuetze, W.P. (1993) “What is an asset?” Accounting Horizons
Wolnizer, P. (1987) Auditing as Independent Authentication, Sydney University Press.

84 MARK TO MARKET ACCOUNTING

7
New chief accountant’s wish list
Address to the Nineteenth Annual AICPA

National Conference on Current SEC

Developments, Washington, 7 January 1992

I wish to thank Mr Huff and the AICPA’s SEC Regulations Committee for the
invitation to address the conference this morning.

My position here today is unique. I will not take up my post as chief accountant
to the commission until two weeks hence. And my separation from my firm will not
occur until shortly before I take my post at the commission, which will allow me to
take a few days of accumulated vacation. So, I need to issue the standard SEC
disclaimer that the views I express here are mine and do not necessarily reflect those
of the commission or members of the staff of the commission. By like token, the
views I express here today do not reflect the views of KPMG or its partners and staff.

What I want to discuss today are some broad, general themes that I intend to
pursue and develop at the commission. First, I want to state that I intend to observe
the policy of the commission as set forth in Accounting Series Release 150, which
was issued in 1973, regarding the establishment of financial accounting and
reporting standards. In ASR 150, the commission said that, while it reserved its
authority and responsibility under the Securities Acts, it would look to the Financial
Accounting Standards Board in the private sector to set standards. So I do not
intend to take pen in hand and rewrite old standards or write new ones unless I
believe that is necessary for the protection of investors.

I want to discuss two themes, namely, simplicity and relevance in standard setting
and financial accounting and reporting. Uniting those two themes and objectives,
and keeping them always in sight, I think will be in the best interests of users of
financial information, both in the short term and long term. And I think that those
two themes and objectives are so fundamental and common that all of us in this
room and standard setters and regulators, wherever situated around the world, can
embrace them.

I wrote an article entitled “Keep it simple,” which was published as commentary
in Accounting Horizons in June of last year. In that article, I suggested that the FASB
write simpler accounting standards than it has in the past.

I do not mean to criticize the board’s prior standards by that call for simpler
standards in the future. Indeed, I think that many of us have participated for the
last ten to twenty years in complex standards. I know that I have. I did some of that
while I was technical adviser to Joe Cummings on the Accounting Principles Board
in the 1960s, while I was at the FASB in the 1970s, while I was on the AICPAs
Accounting Standards Executive Committee in the 1980s and 1990s, and when I
participated at meetings of the Emerging Issues Task Force in the 1980s and 1990s.
The SEC’s staff has, over the years, also been a party to making the rules for
financial accounting and reporting complex. We can all say that we helped out. I
suggest that we all stand back and try to put ourselves into the shoes of the investor
and creditor and ask whether this welter of complexity that we have created, and
continue to create, really helps those people to make lending and investing
decisions. My judgment is that we have gone too far.

Having said that, however, let me also say that I do not agree with the call for
broad, general standards that are left to the judgment of the preparer of the financial
statements to implement and its independent auditor to audit the results of that
implementation. We have tried that approach in the past in this country and it did
not work. For example, there was a broad, general standard on pooling-of-interests
accounting in Accounting Research Bulletin 48, but it did not work. We had a
broad, general standard on lease accounting, in Accounting Principles Board
Opinion 5, but it did not work in that very few lessees recognized any leased assets
and related liabilities on their balance sheets. We have a broad, general standard on
when to recognize credit losses in FASB Statement 5 on contingencies, which I
signed, and it does not work very well in that the results under it are too widely
dispersed. Holders of large loans, which are primarily financial institutions, and
independent auditors of those institutions, under that broad, general standard, do
not have a good grip on when to recognize credit losses or how to measure them. I
think because those and other broad, general standards did not work, we went into
the detailed and complex standard-writing business.

As a concept, I am attracted to the idea of regulators and standard setters issuing
broad, general standards. However, I have been at this business long enough to
know that that will not work very well. At best, that approach results in extensive
non-comparability among and between reporting enterprises. At worst, that
approach results in abuse and perhaps even fraud. People will, in good faith,
interpret broad, general rules in just that way; some people will be conservative, some
liberal, and some in between; and that produces wide non-comparability in
financial reporting. Given that kind of broad, general standard, independent
auditors have no benchmark or guideline to judge whether their clients have
complied with the standard or rule.

That approach of broad, general standards or rules, allowing for latitude in
interpretation, does not help investors and creditors, who need to be able to make
comparisons among and between alternative investments, and we should help them
do that, not make it difficult or opaque.

86 MARK TO MARKET ACCOUNTING

Well, where does that lead me? Where it leads me is to suggest that standards
have some bright lines—perhaps arbitrary—that will result in uniform application of
the standards and comparability among and between reporting enterprises, not only
in this country but also in others.

Some people say that business arrangements are more complex than they used to
be, so the accounting has to be equally complex. And some say that they object to
bright lines because it eliminates judgment. I understand those arguments, but I do
not agree with the answers that are produced as a result.

Let me move to my second major theme, that is, relevance in financial reporting
and mark-to-market accounting, which, in my opinion, go hand in hand with my
ideas about simplicity in accounting standards.

The commission’s views on mark-to-market accounting were set forth by
Chairman Breeden in testimony before the Committee on Banking, Housing, and
Urban Affairs of the United States Senate on 10 September 1990. In that
testimony, Mr Breeden said that there should be a move to mark to market by financial
institutions:

The [Senate Banking] Committee’s last question focuses on a matter that is
also a major area of current Commission concern: the valuation of financial
instruments held by financial institutions. Under current practice, GAAP
[generally accepted accounting practices] for banks and thrifts are based
principally on a historical cost framework. These institutions are permitted to
carry assets on their books at amortized cost, even in instances where the
current value of the assets has eroded substantially, and where a market-based
standard would provide a far more accurate measure of the institution’s
financial health.

As we enter the decade of the 1990s, we should consider a fundamental
shift in the goal we set for the accounting standards for financial institutions.
Such institutions are in the business of buying and selling financial
instruments, all of which have a value measured in terms of current market
conditions. Determining the current value of an institution’s assets… should
increasingly be the goal toward which we must work.

In that same testimony, speaking in a broader context than only financial
institutions, Chairman Breeden also said:

Steps currently being taken to clarify the accounting treatment for investment
portfolios should be part of a broader move in the direction of mark-to-
market accounting. The benefits of market-based accounting warrant
consideration of a broader shift in this direction. The presumption that
market-based information is the most relevant financial data attribute should
be recognized. It may be appropriate to utilize historical cost only where
specifically justified by the circumstances….

ACCOUNTING FOR ASSETS AND LIABILITIES 87

The Commission recognizes that the move to a full-scale application of
market-based accounting requires careful and deliberate planning. The
Commission is aware that strong views are held and valid concerns exist
concerning a shift to market value accounting. In particular, great care must be
taken to ensure that the costs of implementation and ongoing compliance do
not exceed the expected benefits. With respect to reliability of market value
information, additional work will be necessary to develop reasonable and cost
effective valuation techniques for those assets and liabilities that do not have a
liquid market. We need to explore ways to reduce subjectivity of estimates to
an acceptable level. The Commission does not underestimate the significance
or importance of these and other issues. However, we believe that their
resolution must be aggressively pursued.

My views about mark to market versus historical cost are on all fours with the views
of the commission as articulated in the 1990 testimony. Indeed, I will go one step
further and suggest that this issue has been studied enough in the laboratories of
academic journals and needs to be tested in the crucible of practice.

Last year at this conference, Chairman Breeden said that he was looking for a
chief accountant who was a combination of Genghis Khan, Confucius, and
Superman. What he got is a south Texas country fellow that likes mark-to-market
accounting.

Intuitively, market value information about assets and liabilities has to pass
everyone’s test of relevance. If you, as a user of financial information, were to be
offered a smorgasbord of financial information about an enterprise, including the
historical cost/proceeds of its assets and liabilities and market value of its assets and
liabilities, but were told that you could select only one item, which would you
select? No doubt exists in my mind, or any user of financial information that I have
ever talked to, that the one datum that you would select is market value of the
enterprise’s assets and liabilities.

The trick, of course, will be to find the point of trade-off or equilibrium between
the obvious benefits and the cost of getting market value information that is
sufficiently reliable to be published for use by investors and creditors.

We now have the FASB’s Statement 107, which requires disclosure about the fair
value of the financial assets and liabilities, both on and off the balance sheet. I
applaud the FASB for getting that document on the street. Up to now, disclo sure
of fair value of financial instruments has been limited to assets such as marketable
equity securities and certain bond-type securities. The disclosures under Statement
107 will be much more extensive and robust, and I suspect that some enterprises
will go so far as to make the disclosures all in one place so that users of the financial
statements, in one glance, can see the fair value of all of the financial instruments of
the enterprise.

I look forward to seeing the results of Statement 107. I also look forward, eagerly
look forward I might say, to other uses of fair value/market value information now
being addressed by the FASB, namely, formal recognition in the financial

88 MARK TO MARKET ACCOUNTING

statements of fair value of both stocks and bonds and the measurement of impaired
loans by the application of market discount rates to revised estimated cash flows
under the loan contract. I understand that Mr Leisenring will discuss both these
projects later today.

The final matter that I want to mention is harmonization or internationalization
of accounting standards. This issue does not involve a general theme, except that I
think one can usefully think about simplification and the relevance of mark-to-
market accounting as being related to the way we and others around the world
perhaps should approach and work on achieving greater harmony in accounting
standards. While I have not yet formulated thoughts as to how to approach this
issue, I know that it has been the position of Chairman Breeden that the
commission does not want to see a relaxation of our general approach of being
neutral in formulating accounting standards or in the results that are reported under
current standards. The commission has resisted pressure to remove the requirement
that foreign registrants reconcile their earnings and equity using US generally
accepted accounting principles and disclosing the differences from their home-
country presentation.

In closing, I wish to indicate that George Diacont, who has been acting chief
accountant for about a year, has been very helpful in briefing me on current items at
the commission. I look forward to working with him and all of the other members
of the staff and members of the commission. That said, I also should say that there
are important staff positions to be filled, such as that of the deputy chief accountant
and several GS-14 slots. We will be posting those slots, or some of them, in due
course, and I would appreciate your bringing to my attention the resumés of good
people either in this audience or among your colleagues back home.

I will be here today and tomorrow to listen to the discussions. I look forward to
informal conversations with many of you during the course of the conference.

ACCOUNTING FOR ASSETS AND LIABILITIES 89

8
Relevance and credibility in financial

accounting and reporting
Address to American Accounting Association, 12 August 1992

I am quoted as follows in the June 1992 issue of The Journal of Accountancy.

I do not think the users of financial statements have been well served over the
last 10 to 15 years…I think financial accounting and reporting have lost some
of their credibility, and we need to improve their relevance.

I want to continue that theme today.
Almost all of Washington and almost all of the banking, insurance, and thrift

industries are pleading with the Financial Accounting Standards Board not to adopt
mark-to-market accounting for debt securities held as assets. Congressmen, banking
regulators, and the Secretary of the Treasury are saying that it would be wrong to
change from historical cost to mark-to-market accounting for debt securities such as
US treasuries, agencies, state and local governments, and mortgage-backed securities
held by banks, thrifts, credit unions, and insurance companies.

Why do I think we should jettison historical cost accounting and adopt mark to
market for marketable securities? The reasons are simple and straightforward.

The first reason is usefulness. One does not use historical cost numbers to make
investment or lending decisions. No banker has ever made a collateralized loan to a
customer based on the customer’s historical cost of the collateral; the banker insists
on knowing the market value of the collateral. No investor in any asset ever made an
investment based on the seller’s cost of the asset. No investor in a bank’s stock, or a
depositor with funds in excess of $100,000, or an annuitant or other insurance
company policyholder, should be asked to rely on the historical cost of a bank’s or
insurance company’s investment in bonds. Congress established in ERISA that
pensioners need to know the market value of pension plan assets; no pensioner
would be satisfied with the historical cost numbers for pension plan assets. Congress,
in the Investment Company Act of 1940, required that all mutual funds mark to
market their assets; broker/dealers do the same under the 1934 Act; mark to market

is necessary so that customers and investors have up-to-date useful information to
make investment and credit decisions. People who invest in or lend money to
banks, thrifts, insurance companies, and credit unions deserve the same treatment.

The second reason is managed income. Historical cost accounting for debt
securities allows the management of an enterprise to manage income; that is,
management can select when it sells securities and thereby trigger a realized gain or
loss. Preparers of financial statements often object to volatility of income in general.
In this case, volatility is recognized in the period that management wants it to be
recognized, not when the volatility actually occurs in the market value of the
securities. The same amount or degree of volatility is present; it is just recognized in
a different accounting period.

Moreover, if management wants to paper over a bad quarter or year because of,
for example, bad debts being charged to income or because a hurricane requires an
insurer to pay a lot of claims, management “cherry picks” some winners from the
bond or stock portfolio and sells them so as to offset the bad debt loss or the
hurricane claim losses. We have observed that phenomenon repeatedly.

More importantly, this discretion promotes wide non-comparability in reported
income and capital (shareholders’ equity). We all know that 1991 was a good year
for bonds. Some holders of bonds sold the bonds, reaped the gains, and thereby
increased income and capital. Other holders of bonds did not sell; those holders
have unrealized gains residing in their balance sheets. Even with disclosure of
realized and unrealized gains and losses, that condition makes it very hard for the
investing public to compare, for example, Bank A or Insurance Company A with
Bank B or Insurance Company B. Financial accounting and reporting should make
comparable things look comparable, and should make comparison easier not harder.

The third reason is interest rate risk. Historical cost is used for debt securities
provided management has the intent and ability to hold those assets on a long-term
basis or to maturity, so-called accounting by psychoanalysis. Many financial
institutions currently use their bond investments to “manage” interest rate risk, to
manage foreign exchange risk, to manage taxable income, to manage liquidity, and
to respond to loan demand. As we have seen in the last several decades, interest rates
fluctuate widely. So do foreign exchange rates. So does loan demand. Managers of
financial institutions respond by buying or selling securities. Management is
responding to outside, uncontrollable forces. These responses are inconsistent with
representations about intent to hold for the long term or to maturity. It is not
credible to assert that one intends to hold bonds in the bond portfolio for the long
term or to maturity while saying in the same breath that the investment securities
portfolio is used to manage interest rate risk or is sold in response to loan demand.

A stated intent to hold to maturity or for the long term is an empty promise, an
incorrect assertion, if it is broken or contradicted when interest rates change, loan
demand rises, or some other uncontrollable event comes along and management
decides to sell so-called investment securities.

A fourth reason for the use of market value involves credit losses. Holders of
corporate bonds should, at least in theory, recognize credit losses as the credit

MARK TO MARKET ACCOUNTING 91

standings of bond issuers decline. But that’s theory. In practice, holders of corporate
bonds do not recognize credit losses until the bond issuer is bankrupt or nearly so.
Independent auditors condone this practice because the accounting rule is so
judgmental and abysmally lax that loss recognition is delayed far beyond reason.
The Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and
state insurance regulators learned that, too late.

On that score, we now have an exposure draft of a new accounting standard from
the FASB on the recognition and measurement of credit losses, which the board
calls loan impairment. Under the proposal, loan impairment would be recognized
“when, based on current information and events, it is probable that a creditor will
be unable to collect all amounts due according to the contractual terms of the loan
agreement.” When a loan is judged to be impaired under the standard of
probability, the creditor would measure impairment by reference to the present
value of the expected future cash flows of the impaired loan using the effective
interest rate of the loan. For loans with no discount or premium or net deferred
costs or fees, the effective rate is the coupon rate. The FASB considered using a
market rate instead of the effective rate but decided on the effective rate. The board
apparently never considered any other measure of impairment than the probability
standard applied to expected cash flows.

I am very disappointed in the board’s conclusions on both of those matters. First,
the probability standard does not work; that has been demonstrated by the wide
variability in current practice. The General Accounting Office has been extremely
critical of that approach; the GAO’s criticism is based on its review of failed banks,
where the allowances for credit losses were badly understated. Saying that it must be
probable that the principal and interest will not be collected is looking down the
wrong end of the pipe; a lender assumes that principal and interest will be collected
as per the loan agreement and then allows for risk through the rate.

Second, despite some cautionary words, the draft allows the measure of
impairment to be made independently of market prices and what market
participants think about a debt issuer’s credit. Assume that a bond is traded on the
New York Bond Exchange and that interest rates have not moved a tick since the
bond was issued. The bond can be quoted at an amount less than 100, say, 95, 90,
or 85, yet the holder of that bond judgmentally may conclude that it is not probable
that the loan will not be collected as per schedule and therefore no impairment need
be recognized. Under FASB Statement 107, the fair value of that bond will have to
be disclosed somewhere in the financial statements of the holder of that bond. I
think that the public will not understand how it can be that two values are being
reported and disclosed for the same bond, 100 and an amount less than 100. I think
the public will be confused. I think the public will conclude that impairment as
measured by the market is the relevant measure of impairment and not the amount
as measured under the FASB’s standard. I think that the FASB’s proposal will
diminish its standing in the eyes of the public.

However, what I am most concerned about is the measurement of capital. This is
more than one accountant’s debate with another accountant about the best way to

92 ACCOUNTING FOR ASSETS AND LIABILITIES

allocate a cost among various accounting periods. I am talking about more than
accounting elegance. How we measure loan impairment concerns whether financial
institutions should be required by the cognizant regulator to raise more capital or
reduce their asset holdings and liability levels, or, indeed, whether they may keep
open their doors.

A fifth reason for mark-to-market accounting is market efficiency. Free markets
are wonderful things. Ours are marvelous. Markets price assets daily, hourly, and by
the minute, at no cost. Use of historical cost for assets and such notions as intent to
hold to maturity and “other than temporary declines” in price interfere with market
efficiency. To the extent that marketplace participants believe that the reported
numbers have been skewed by artificial restraints, the market exacts a penalty in
pricing the securities issued by reporting companies.

A sixth and final reason concerns capital adequacy Financial institutions have
explicit or implicit capital-adequacy requirements. Banks, for example, must have $8
of capital for every $100 of “risky” assets, such as loans. Under the accounting rules,
declines in market values of debt securities are not recognized if the holder has both
the intent and ability to hold the securities to maturity or on a long-term basis.
Whenever the price of a debt security goes below the historical cost of the security,
reaching a conclusion that the enterprise has the ability to hold the security to
maturity implicitly requires an interest rate forecast. First, management of the
reporting enterprise must conclude that, even though interest rates have risen, that
condition will not persist for so long that the enterprise will be forced to sell the
security at its reduced price to get cash to meet obligations. Alternatively, the
management must conclude that interest rates will fall in the near term, the price of
the security will increase, and the enterprise will not have to sell the asset at a loss. Then
the enterprise must get its independent auditor to agree to that forecast, at least
implicitly.

Second, the reporting enterprise must conclude that its regulator will allow it to
continue to operate and not force it to sell the security at its reduced price even
though the real capital of the enterprise is impaired. The enterprise must get its
independent auditor to agree with that conclusion as well, at least implicitly.

I think that it is not within the competence of independent auditors to make
interest rate forecasts, and independent auditors should not be responsible for
judgments about forbearance from laws and regulations. I think that it is the
responsibility of banking, thrift, insurance, and credit union regulators, and
ultimately Congress and the public, to decide when forbearance from laws and
regulations is appropriate, not independent auditors. Besides, once an independent
auditor has agreed that a decline in market value below cost need not be recognized
and thereby not reduce the reported amount of capital, he or she then becomes
wedded to that decision and will not reverse it, because to do so is to admit error, or
at least fallibility, not to mention the exposure to litigation. The auditor then has a
vested interest in the client’s interest rate forecast and psychologically may no longer
be independent in the deepest meaning of that word.

MARK TO MARKET ACCOUNTING 93

However, the critical point here is regulatory forbearance. Under a recent FASB
standard—FASB Statement 107—all entities will have to disclose the market value
of their marketable securities portfolios, both debt and equities. Many assert that
with those disclosures the cognizant regulator has all the information necessary to
make regulatory decisions. True. Marking to market right on the face of the
financial statement will not change the facts; what marking to market will do is require
regulatory authorities to make explicit decisions about whether regulated enterprises
have met their capital requirements, whether those enterprises need to raise more
capital, reduce their assets and liabilities, or indeed whether they may keep their
doors open to the public. Those explicit decisions then cannot be postponed or
sloughed off as they can if the mark to market is only in the footnotes and not
formally accounted for on the face of the financial statement. I am talking about
something more than bean counting by people wearing green eyeshades. I am
talking about more than accounting elegance. I am talking about whether financial
institutions that are entrusted with the public’s money are allowed to keep open
their doors and take in more of the public’s money.

Look what the use of historical cost got us in the savings and loan debacle. The
final tally will not be in for years, but the cost to the American taxpayers, and
society in general, will be enormous.

The use of historical cost did not cause the S&L problem, but the use of historical
cost is to blame for the loss of some of that money down the S&L hole. Because the
S&Ls could say that the acquisition, development, and construction arrangements
were loans and not real estate, and were fully collectible, but did not have to disclose
their fair value, never mind write the ADC loans down to fair value, ADC loans kept
growing and growing on S&L balance sheets. Accounting income from such loans
also kept growing, even though no cash income was being collected. For the
marketable securities and regular residential mortgage loans that S&Ls held, and
which were significantly under water in the high interest rate environment of the
early to mid-1980s, no write-down was required by the applicable accounting
standard, or at least practice under that standard, so long as the S&L had the stated
intent and ability to hold the securities and loans to maturity. Historical cost was
OK.

So, even though it was known by the S&L regulator that the real equity of the
S&Ls was a huge negative number, the S&Ls were allowed to stay open and to keep
making risky investments with taxpayers’ money. They kept rolling the dice. When
the FSLIC and FDIC took over the failed S&Ls and savings banks, however, they
found that the size of the hole was huge. But under generally accepted accounting
principles, no hole, or only a small hole, had been reported. None of the S&Ls, or
their auditors, had critically examined whether the S&Ls had the ability to hold
those assets. That ability was wholly dependent on the S&Ls not being shut down
by the regulator and was therefore of very questionable fact. The analysis was
circuitous. The regulator implicitly said that the S&Ls would not be shut so long as
reported equity was positive, and the S&Ls kept accounting for their marketable
securities and mortgages at cost so long as the regulator did not shut the doors; the

94 ACCOUNTING FOR ASSETS AND LIABILITIES

circle was closed; thus the parties involved were able to say that the ability-to-hold
criterion was met.

If the S&Ls had been forced to disclose, never mind account for, the fair value of
their ADC portfolios and their bond and mortgage loan portfolios, does anyone
honestly believe that the S&L hole would have gotten as deep as it did? I think the
fair answer to that question is “No.”

Let me turn to a closely related matter, namely litigation against public accounting
firms, which also involves relevance and credibility in accounting. Litigation is said
to threaten to obliterate a significant portion of the profession, at least that portion
of the profession that audits the financial statements of public companies. The
profession is going to various state capitals and to Capitol Hill in Washington
asking for relief from various laws. The profession claims that it is the subject of
abusive and frivolous lawsuits by shareholder/investors. Members of the profession
also cite cases where their “deep pockets” have been opened to pay for the sins of
more culpable, but now insolvent, audit clients. The profession is lobbying hard for
litigation reforms, including a major push to restrict joint and several liability.

I am very concerned about abusive litigation against accountants. So is the
commission. The commission has suggested that Congress look at proportional
versus joint and several liability. The commission has stated its support for RICO
reform. The commission has stated its support for the proposition whereby the loser
of non-meritorious litigation pays the winner’s costs. However, getting reform
through federal Congress and the various states will take a long time, if it ever
comes.

Meanwhile, the profession, with a few exceptions, is not doing anything about
the underlying causes of litigation against itself. It will not pull on its own
bootstraps. The profession will not go to its clients and tell those clients that their
balance sheets have to have realism in order to elicit unqualified opinions. Why not?
Well, that could involve being tough with a client. Maybe make the client angry.
Maybe the client will go across the street to another auditing firm and that firm will
agree to report on a balance sheet that has outdated or irrelevant representations in
it.

The profession, again with an exception or two, will not go to the FASB and
support realism in financial accounting and reporting. The profession will not reach
tough, unpopular decisions. Why is that? Is it because the profession has become so
beholden to its clients that it will not speak to them about realism and relevance and
credibility in financial accounting and reporting? Let me list only a few situations
where the profession has become a cheerleader for its clients.

1 Troubled debt restructurings. The profession, in response to its bank clients,
asked the FASB to issue Statement 15 more or less as the FASB did back in
1977. That document allows for restructured loans to be reported at 100 cents
on the dollar even though that dollar will earn no interest and will not be
collected until many years in the future. FASB Statement 15 has plunged an
entire generation of accountants into darkness. Fortunately, the FASB is now

MARK TO MARKET ACCOUNTING 95

proposing to change that standard so as to remove that part of it which is so
grossly bad, but the new FASB proposal itself is flawed because of measurement
of the loss on in substance foreclosed assets by using the effective rate rather
than a market rate.

2 Pension plan values. When pension accounting was being reconsidered, the
profession, at the behest of its commercial and industrial clients, went to the
FASB and suggested that the volatility in pension plan assets and liabilities not
be recognized immediately and in full in income and equity. They argued that
the FASB should create an artifice to keep the income statement and
shareholders’ equity from being affected too much by changes in the values of
plan assets and liabilities. The FASB obliged in Statement 87, and now we have
delayed recognition of changes in values of plan assets and liabilities.

3 Deferred tax assets. APB Opinion 11 produced deferred tax asset and liability
numbers that no one could explain. When the FASB fixed that problem in
Statement 96 a few years ago and permitted the recognition of deferred tax
assets only when the amounts could be recovered through the operation of a
carryback, the profession, at the behest of its clients, let out a howl. Even
though it clearly was not in their best interests to do so, all the large accounting
firms went to the FASB and pleaded with the board to allow recognition, on a
judgmental basis, of deferred tax assets that will be recovered, if at all, years and
years into the future and only if there is future taxable income.

The FASB obliged in Statement 109. The claim was, under old Opinion 11, that
the deferred tax liability was a “UGO,” an “unidentified growing object,” because
the amount kept getting larger and larger. The deferred tax asset under FASB
Statement 109 has the potential to be a “UGO” in reverse. What are the users of
financial statements going to do when they see those deferred tax assets? If they are
sophisticated, they are going to exclude those assets from income and equity or
discount them heavily. If they aren’t sophisticated, I don’t know what they will do.
What is going to happen when those deferred tax assets are not realized? I know
what will happen. The accounting firms will be sued.

4 Investment versus trading. In 1990 and 1991, we have seen financial institutions
sell 25 percent, 50 percent, 75 percent, even 95 percent of their entire self-
designated investment securities portfolios during the year despite their
assertions in the footnotes that they intend to hold the securities to maturity or
for the long term. One insurance company turned its long-term US Treasury
bond portfolio eight times in 1991. Yet, remarkably, every one of those
institutions’ financial statements received the unqualified opinion of its outside
auditor.

5 SEC filings. In SEC filings, we sometimes see what I call incredible accounting.
When our staff challenges the incredible accounting, it becomes clear that the
auditor did not concur with his or her client’s accounting but nonetheless
signed an unqualified opinion hoping that our staff would challenge and object

96 ACCOUNTING FOR ASSETS AND LIABILITIES

to the accounting and thereby become the bad guy. Our staff is being used as
the auditor’s leverage, but only after the auditor agrees to the incredible
accounting.

I could list other examples, but I have made my point.
What is the purpose of my bringing this issue to the fore? Well, I think that

instead of thinking simply of its clients and itself, the profession needs to give some
thought to the public that it serves, to the investors and creditors and employees
who put up their money and their labor to make investments in the profession’s
clients.

I suggest that the profession go to the FASB and ask it to issue accounting
standards that produce more relevant, more understandable, more useful, and more
credible financial statements than what we now have. That the profession ask the
FASB to issue accounting rules that produce bulletproof balance sheets instead of
what we now have. Bulletproof in the sense that assets are not stated in excess of
market values. That the profession ask the FASB to issue accounting rules that
respond to and correspond with real-world, outside-of-accounting phenomena, like
market values of assets instead of such arcana as undiscounted cash flows and
delayed recognition of changes in value of pension plan assets and liabilities. That
the profession ask the FASB to issue accounting rules that result in financial
statements that investors can understand and use instead of accounting rules that are
arcane and idiosyncratic and produce financial information that only other
accountants can understand.

The accounting profession keeps saying that instead of reporting real assets, hard
assets, at current value, its clients should continue to be able to use historical costs
and deferrals and allocations of costs and losses and that the profession should then
be able to apply its judgment to the recoverability of the amounts of deferrals
reported by its clients. But the profession then says, when it is sued, that it should
not be held responsible when those deferrals and those judgments turn to clabber
instead of cream. I submit that if reporting companies published relevant, credible
balance sheets that are bulletproof the profession would not get sued. Or, if it got sued,
the plaintiffs would not prevail on the merits.

What if those who are crying wolf are right? What are the implications of a major
firm being bankrupted by damage awards because of overstatement of asset values? I
truly hope that does not happen. That would be tragic for any firm and the
individuals involved. Investors would suffer. But what if it did happen? What would
that imply for the Securities and Exchange Commission? Would that suggest that
the commission step into the accounting standard-setting process and require that
assets not be reported in balance sheets at amounts in excess of market values?
Would that suggest that the commission mandate rotation of auditing firms so as to
make it more likely that auditors who know they will be replaced will not allow
clients to report assets in excess of market values? I do not know the answer to those
questions, and I do not want to find out.

MARK TO MARKET ACCOUNTING 97

I urge the Financial Accounting Standards Board and the accounting profession
to address the issues of relevance and credibility in financial accounting and
reporting so as to maintain their own relevance and credibility.

98 ACCOUNTING FOR ASSETS AND LIABILITIES

9
Why are we all here anyway?

Speech delivered at the University of Texas at Austin Theta Chapter of

Beta Alpha Psi on the occasion of the Accountant of the Year award,

12 November 1993

Good evening. It is indeed a pleasure and honor to be recognized by the Theta
Chapter of Beta Alpha Psi as your Accountant of the Year.

I especially want to thank you for inviting my wife, Jean, and several members of
our family to be here this evening to join us: my mother and stepfather, Mr and
Mrs Milton Taylor, my aunt and her husband, Durinda and G.C.Slough, and our
son and grandson, Brian and Bryce Schuetze.

I remember an evening such as this one thirty-seven years ago, when I was
inducted into this chapter of Beta Alpha Psi. I would like to say that I remember it
well, but that would be a bit of a stretch. The speaker was an officer from Humble
Oil & Refining Company in Houston, now Exxon USA. I have tried to locate him.
I thought that perhaps he might remember the theme of his talk because I do not.
However, I have not been able to track him down.

The accounting professors who may have been here that evening included Jim
Ashburne, Bob Grinaker, George Newlove, C.Aubrey Smith, Glenn Welsch, John
White, and Charles Zlatkovitch. And going through my file, I was surprised to find
a newspaper clipping about Dean Dennis Ford’s addressing the BBA Wives Club,
where Mrs Edwin Pickett was elected president and my wife was elected secretary.
The Picketts live in Dallas and, after all these years, we still keep in touch with them
through the exchange of Christmas greetings. I also found a program for the Eighth
Annual Honors Day, held on Saturday, 7 April 1956 in Hogg Auditorium, where Dr
Logan Wilson, then president of the university, recognized the faculty and honor
students, and where the Honors Day address was by Dr Benjamin Wright, the
president of Smith College. Fond memories indeed.

Since World War II and since I graduated here in 1957, our economy has been in
a long-term upward trend. In 1957, on 1 July, the Dow Jones Industrial Average
stood around 500. About two weeks ago, the Dow Jones Industrial Average, on an
intraday basis, briefly breached the 3,700 mark and closed just an eyelash under 3,
700. When I started in the practice of public accountancy in 1957, a ten million

share day on the New York Stock Exchange was such a blizzard of paper that the
brokerage houses could not keep track of all the ownership of shares, and dividends
to shareholders sometimes floated in the system for months. Now, daily volume on
the New York Stock Exchange routinely exceeds 250 million shares and was over
600 million in October 1987 when the market crashed. A new house, a so-called
starter house, cost about $12,000—at least that’s what our first one in San Antonio
was. The USSR had not launched it first Sputnik, and of course no one had walked
on the Moon. Now, trips into space last for weeks, even months, and no one seems
to notice very much. Only CNN now televises our space launches live, and I
wonder how long that will last.

The price of oil was about $3 a barrel, and a gallon of gas was about 15 cents.
The price of natural gas was about 10 cents an MCF. Wheat was about $1.90 a
bushel. Corn $1.12. My starting salary in August 1957 was $425 a month.

I do not remember how many accountants there were in 1957, or in 1959 when I
passed the CPA exam and joined the American Institute of Certified Public
Accountants. Today, there are about 300,000 members in the AICPA, about half of
them in the practice of public accountancy. In the state of Texas, there are about 55,
000 CPAs licensed by the Texas State Board of Public Accountancy. The so-called
Big Six accounting firms are now international service organizations. Those six
firms, in the United States alone, generate about $11.6 billion in revenue and have
about 8,350 partners and 72,000 professional staff.

Savings and investment have also been spectacular during that timespan. There
are now more than 51 million individual investors in this country. People like us in
this room. Open-ended mutual funds alone have about $1.8 trillion of assets under
management. Look in your daily newspaper, say USA Today, and you will see listed
about 4,000 open-ended mutual funds. They range from giants like Fidelity’s
Magellan and Vanguard’s Windsor to very small funds. In addition, there are vast
institutional holdings of stocks, bonds, loans, real estate, and the like, mostly
through pension funds. TIAA/CREF, the college school system retirement vehicle,
has assets of $110 billion; it is the largest in the world. The Texas State Teachers
Retirement System manages upwards of $31 billion of assets. The California Public
Employee Retirement System has about $69 billion in assets. The various pension
and retirement plans of General Motors have assets of about $40 billion; GE’s
exceeds $36 billion. Not to mention the assets held by about 12,000 commercial
banks, 2,000-plus savings and loans and savings banks, thousands of insurance
companies, credit unions, and broker/ dealers such as Merrill Lynch and Charles
Schwab.

You may ask, what has all of that got to do with why we are all here tonight?
What has that got to do with accounting anyway? Well, I’m here to tell you that it
has got everything in the world to do with accounting.

Accounting is the lubrication that allows this country’s capital markets engine to
turn at very high RPMs without overheating. There are about 13,400 public
companies in this country. Like General Motors, General Electric, General
Dynamics, General Mills, and General Reinsurance. 4,000 mutual funds. 8,000

100 ACCOUNTING FOR ASSETS AND LIABILITIES

broker/dealers, 20,000 banks, thrifts, credit unions, and insurance companies. Every
one of them keeps books and records. Everyone of them prepares
financial statements at least annually and most of them quarterly. All of them, except
for the very smallest, are required by some law or regulation to have their financial
statements audited by independent certified public accountants. Over and above
those public companies and financial institutions, there are thousands, millions, of
small, closely held, private companies. The local hardware store. The dry cleaner.
The construction company. The bakery. And all of them need financial statements,
mostly for their bankers and their owners and the owners’ families.

Wait, I am not finished. There are fifty state governments. Thousands, dozens of
thousands, of cities, counties, water and sewer districts, bridge and tunnel
authorities, and toll roads. They all prepare financial statements. Most of these
financial statements need to be audited.

There is more. Churches and temples. Colleges and universities. Charities like Boy
Scouts and Girl Scouts and United Way. Thousands of them. They prepare
financial statements, and most of them need audits.

There is still more. The US Treasury and various states need money to run, and
we all prepare tax returns so as to compute the amount of money to send to
Washington and state capitals and in some cases to cities that have income tax
systems.

And, finally, in order to prepare all these financial statements and all these tax
returns, we need accounting systems. Indeed, to run all of these businesses,
governments, schools, churches, charities, and what have you, we need accounting
systems to gather and produce information. Who does all of that? Accountants do
all of that. That is why we are here this evening.

Let me spend just a few minutes with you on the one thing that I have found to
be the most important as I have traveled through this world of business and accounting
for thirty-six years. That is, high ethical standards. Whatever your chosen field,
management accounting, financial accounting, tax accounting, or accounting
systems, you will of course want to be proficient in that field. You will prosper
financially if you do good work, for good work is its own best referral.

It has been my observation that those who are the most fulfilled are those who not
only do good work but who do it on the up and up, on the straight and narrow,
with no corners rounded. It is they who are sought out most often by their
colleagues, by their superiors, by their clients, by new clients, and by the public.

In my opinion, the next thirty-six years hold great promise for you young people
in this audience. To be sure, right now our economy and the economies of the major
industrial countries are in somewhat of a slowdown. It could be that the slowdown
will get worse before it gets better. But, for you in this audience, that will be but a
momentary blip on the radar screen of life. Let me tell you why I say that.

Three years ago, the Berlin Wall came down. Communism is no longer a way of
life for people behind the Iron Curtain. From Budapest to Vladivostok, there are
more than 300 million people who are making the conversion to democracy and
capitalism. We in the West, in the USA and other Western countries, will be able to

MARK TO MARKET ACCOUNTING 101

sell those people tractors, fertilizer, TVs, autos, plants to build tractors and autos,
Coca-Cola, Pepsi, and plain old soap. About six years ago, during Gorbachev’s
regime, the coal miners in Siberia went on strike. They went on strike because after
working ten hours in the mines they came out to wash up but there was no soap.
There was no soap. Proctor & Gamble will be glad to sell them soap. There are 1.1
billion people in China. They need tractors and cars and computers and Coke and
Pepsi and TVs and maybe even soap. The same goes for 800 million in India.
Millions more in Pakistan.

Right here, south of the border, are 90 million Mexicans to whom we can sell
cars and computers. The same goes for Brazil. And I haven’t even mentioned the
African continent.

I see a huge demand for all kinds of good and services to be sold to these millions
of people. That means that economies around the world are going to grow and
expand. And you accountants will be needed to help it to grow and expand. To
gather the information and report on it. To do the accounting.

It has indeed been a pleasure to be here this evening.

102 ACCOUNTING FOR ASSETS AND LIABILITIES

10
Accounting for restructurings

Address to Financial Executives Institute, Current Financial

Reporting Issues Conference, New York Hilton Hotel and Towers, 8

November 1994

Thank you for inviting me to speak again at your annual conference. This is now
the third time I have appeared here. My remarks are mine and mine alone. I do not
speak for the commission or any of the other staff.

Last year, at this conference, Robert Bayless, in his remarks, discussed accounting
for restructurings. In the question and answer session that followed, in which both
Robert Bayless and I participated, it became clear that there was not a meeting of
minds between FEI people in the audience and the SEC’s staff on accounting for
restructurings.

Restructurings are not new. There is an SEC Staff Accounting Bulletin—SAB
67, issued in 1986—that deals with restructurings. SAB 67 deals with the geography
of restructuring charges in the income statement and what disclosures there should
be about restructurings in management’s discussion and analysis. SAB 67 does not
address when restructurings should be recognized, what the ingredients thereof
ought to be, or how restructuring charges should be measured.

After that FEI conference, we went back to our office and began to look into what
companies were doing in the area of restructurings. We found that restruc turings
had, in the past several years, grown substantially in number, and the amounts of
the restructuring charges had increased dramatically. We also found that the
ingredients of restructuring charges were diverse. We found that a large fraction of
many restructuring charges were employee-related costs, such as termination and
other related benefits. Benefits for employees that were to be terminated not just in
the following year but planned to be terminated two, three, five years hence. Also
included in restructuring charges were write-downs or write-offs of costs incurred in
prior periods, such as plant cost, where decisions had been taken to dispose of assets
and estimated proceeds to be received on sale and the assets were expected to be less
than cost, or simply to abandon the assets in some cases. We also found an odd
assortment of other things, which mostly were to get rid of sundry old costs that had
accumulated on balance sheets over the years. Lastly, we found that restructuring

charges included expenditures to be made in the future for the benefit of future
operations; included in this category were future expenditures for equipment such
as computers, software for those computers or computers already on hand,
relocating and retraining employees, advertising and legal services, consulting
services, expected adverse factory overhead variances on future production runs,
expected increases in returns and allowances on future sales, increased warranty
liabilities on future sales, and the like, all related to future operations.

The upshot of our investigation was that in January we asked the Financial
Accounting Standards Board’s Emerging Issues Task Force to address accounting
for restructurings. The task force discussed accounting for restructurings at its
March, May, June, and September meetings and will discuss it again next week.

In May, with respect to termination benefits, the task force concluded as follows:

6 At the May 19, 1994 meeting, the Task Force discussed when an employer
should recognize a liability for the cost of termination benefits that management
decides to provide to involuntarily terminated employees. That discussion
addressed the accounting for involuntary termination benefits that are not
associated with a disposal of a segment or a portion of a line of business and are
not paid pursuant to the terms of an individual deferred compensation
contract. The discussion covered situations in which employees would be
terminated as a result of management’s decision and would receive termination
benefits that they would not have otherwise been entitled to under any pre-
existing arrangements. Further, the benefits would not be ongoing for
employees not terminated in connection with the current plan of termination.

7 In those situations, the Task Force reached a consensus that a liability for
employee termination benefits should be recognized in the period management
approves the plan of termination if all of the following conditions exist:

a Prior to the date of the financial statements, management having the
appropriate level of authority to involuntarily terminate employees approves
and commits the enterprise to, the plan of termination and establishes the
benefits that current employees will receive upon termination.

b Prior to the date of issuance of the financial statements, the benefit
arrangement is communicated to employees. The communication of the
benefit arrangement should include sufficient detail to enable employees to
determine the benefits they will receive if they are terminated.

c The plan of termination specifically identifies the number of employees to
be terminated, their job classifications or functions, and their locations.

d The planned terminations will occur within one year from the date that
management approves the plan of termination unless circumstances outside
the control of the enterprise (in other words, legal or contractual restrictions
on the enterprise’s ability to terminate employees) are likely to delay the
termination date (for example, existing union contracts or enacted legal

104 ACCOUNTING FOR ASSETS AND LIABILITIES

restrictions concerning the length of notice required to terminate
employees).

After discussions in July and September, the task force tentatively concluded that
liabilities for future expenditures for computers, computer software, relocating and
retraining employees and other items that will benefit future operations should not
be recognized early and included in restructuring charges. However, the task force
also tentatively concluded, after discussion in July and September, that future
expenditures related to a plan to exit an activity may be recognized as a liability
prior to the time the activity is exited and prior to the time a liability would be
eligible for recognition without such an exit plan. The minutes of the September
meeting of the task force read as follows on this latter point:

13 At the September 21–22, 1994 meeting, the Task Force discussed when an
enterprise should recognize a liability for costs, other than employee
termination benefits, that are directly associated with a plan to exit an activity
(exit plan) including certain costs incurred in a restructuring. That discussion
focused on identifying costs that should be recognized as liabilities at the time
that management commits the enterprise to an exit plan (commitment date).
The Task Force observed that the tentative conclusions in paragraphs 14–21 of
this Issue do not apply to the disposal of a segment of a business accounted for
under Opinion 30 or to asset impairments arising from an exit plan. The Task
Force also observed that the accounting for impairment of long-lived assets will
be addressed when the Exposure Draft of the proposed FASB Statement,
Accounting for the Impairment of Long-Lived Assets, issued 29 November
1993, is a final statement.

14 The task force reached a tentative conclusion that a decision by an enterprise’s
management to execute an exit plan that will result in the incurring of costs that
have no future economic benefit represents an obligating event for those costs
meeting the criteria in paragraphs 15–17 of this issue.

15 The Task Force reached a tentative conclusion that a commitment date for an
exit plan occurs when all of the following conditions are met:

a Management having the appropriate level of authority approves and
commits the enterprise to an exit plan.

b The exit plan specifically identifies all actions to be taken to complete the
exit plan, activities that will not be continued, including the method of
disposition and location of those activities, and the expected date of
completion.

c Actions required by the exit plan will begin as soon as possible after the
commitment date and the period of time to complete the exit plan indicates
that significant changes to the exit plan are not likely.

MARK TO MARKET ACCOUNTING 105

16 The Task Force reached a tentative conclusion that only costs resulting from an
exit plan that are not associated with or that do not benefit activities that will
be continued would be eligible for recognition as liabilities at the commitment
date. Costs meeting that requirement should be recognized at the commitment
date if they meet either criterion (a) or (b) and also meet criterion (c) below:

a The cost is incremental to other costs incurred by the enterprise in the
conduct of its activities prior to the commitment date and will be incurred
as a direct result of the exit plan. The notion of incremental does not
contemplate a diminished future economic benefit to be derived from the
cost but rather the absence of the cost in the enterprise’s activities
immediately prior to the commitment date.

b The cost represents amounts to be incurred by the enterprise under a
contractual obligation that existed prior to the commitment date and will
either continue after the exit plan is completed with no economic benefit to
the enterprise or be a penalty incurred by the enterprise to cancel the
contractual obligation.

c The cost is not associated with or is not incurred to generate revenues after
the exit plan’s commitment date.

17 The Task Force agreed to define costs that meet the criteria of paragraphs 15
and 16 of this Issue as exit costs. The Task Force observed that the overall exit
plan may be composed of many different components. The Task Force agreed
that it is not necessary for an enterprise to be able to reasonably estimate the
individual costs of every component of the exit plan at the commitment date. A
liability should be recognized at the commitment date for those exit costs that
can be reasonably estimated. The remaining exit costs should be recognized
when they can be reasonably estimated.

18 The Task Force reached a tentative conclusion that the results of operations
after the commitment date of an activity that will not be continued are not exit
costs. The Task Force also reached a tentative conclusion that for assets to be
disposed of as part of the exit plan, costs to sell those assets are not exit costs.
Expected gains from the sale of those assets should be recognized when realized
(in accordance with Statement 5) and should not be used to offset the liability
for exit costs recognized at the commitment date.

19 The Task Force discussed whether the cash flows for certain costs not otherwise
qualifying as exit costs would be included in determining an asset’s fair value
based on the proposed FASB Statement on Impairment of Long Lived Assets.
The Task Force was not asked to reach a consensus on this issue and agreed to
continue discussion of that issue at a future meeting.

20 The Task Force agreed that costs that do not qualify as exit costs should not be
recognized as liabilities at the commitment date. Costs not qualifying as exit
costs should be recognized as liabilities when an obligation exists to pay cash or
otherwise sacrifice enterprise assets.

106 ACCOUNTING FOR ASSETS AND LIABILITIES

As some of you may know, I was one of the charter members of the FASB. I signed
FASB Statement 5, which was issued in 1975. As you may recall, Statement 5 deals
with catastrophe reserves and contingency reserves. Today, I would like to give you
my analysis of how I think restructuring charges and exit costs and related balance
sheet liabilities or reserves fit into the accounting literature.

The FASB’s definition of a liability in its Concepts Statement 6 is as follows:

Liabilities are probable future sacrifices of economic benefits arising from
present obligations of a particular entity to transfer assets or provide services
to other entities in the future as a result of past transactions or events.
[Footnotes omitted]

I am struggling with how the liability to be recognized by a corporation for the
termination benefits pursuant to the May consensus of the task force fits the FASB’s
definition of a liability. Based on the facts discussed by the task force, it looks to me
as if the “past event” that will make the corporation liable for the termination
benefits is that the employee continues to work up to the time he or she is
terminated involuntarily. If the employee voluntarily leaves prior to the termination
date, he or she receives no benefits. I question how a decision by the corporation’s
management to pay benefits constitutes such a “past event,” because that decision
itself does not obligate the corporation; the corporation becomes obligated only if
the employee works up to the scheduled termination date. Moreover, I question
how a communication of the decision of the management of the corporation to the
employees after the balance sheet date but prior to the issuance of the financial
statement constitutes such a”past event” inasmuch as that communication also does
not obligate the corporation; again, the corporation becomes obligated only if the
employee works up to the scheduled termination date. The benefit does not vest in
the employee until the involuntary termination date. (I recognize that pension
benefits and post-retirement healthcare benefits are recognized as liabilities prior to
when those benefits are “vested,” but that is where there is a contractual benefit plan,
which is not the case in the matter discussed by the task force in May.)

As indicated above, the task force has also tentatively concluded that costs to exit
an activity including certain costs incurred in a restructuring would be recognizable
as liabilities when the management of a corporation has determined that such costs
will be incurred. I am struggling with how the liability to be recognized for such
costs, which liability would be recognized based on a decision by management to
incur a cost, meets the FASB’s definition of a liability. I do not see a “past event”
triggering a liability.

As I understand the FASB’s definition of a liability, a liability arises under a
contract or pursuant to laws or regulations. When employees work, they are entitled
to receive money for their work, and the corporation is obligated to pay the money.
There is a contract between the employer and the employee. When a vendor
supplies goods or services to a corporation, the corporation owes the vendor money
pursuant to the contract between the vendor and the corporation. When

MARK TO MARKET ACCOUNTING 107

corporations borrow money, they must repay the money pursuant to the borrowing
contract. Corporations must pay money to governments pursuant to various laws
and regulations, such as income tax laws, excise tax laws, and property tax laws.
Corporations must spend money to remediate polluted sites because of laws and
regulations. In all of these cases, liabilities are recognized because of the existence of
contracts or laws or regulations. In none of these cases is a liability recognized based
on a management decision to make an expenditure or public announcement of that
decision.

It might be argued I suppose, in the case of a “restructuring,” that a liability may
be recognized because once management has decided to pay cash (or otherwise use
corporate assets) that cash outflow is “probable” of occurrence—indeed it may be
highly probable. But, under the FASB’s definition of a liability, the probability of a
cash outflow, in and of itself, does not create a liability. If probability of a cash
outflow were sufficient alone to justify (or require) the recognition of a liability,
then corporations would or could recognize as liabilities future cash outflows for
salaries and wages, raw materials, advertising, rent, and the like, which is not done
in accounting today.

Then there is the question of verifiability. The FASB concluded, in its Concepts
Statement 2, that verifiability is one of the necessary qualities of representations in
financial statements. Verifiability means that two or more measurers of something
would reach approximately the same conclusion—that the accuracy of something
can be determined. I question how the ingredients of restructuring charges, and the
measure of them, can be verified by outsiders. Those things are known only to the
management of the enterprise.

Moreover, I know of no auditing procedure that the external auditor can execute
to determine whether management of an enterprise is contemplating to exit an
activity or otherwise engage in a restructuring. Let me ask, rhetorically, if
management does not announce to the auditor that an exit or restructuring is
contemplated, what does the auditor do? Does the auditor, and the user of the
financial statement, assume that none is contemplated? The task force has been
unable to define what a restructuring is, so I would not know how to formulate an
accounting standard or rule for when a restructuring is required to be recognized;
likewise, there is no way to formulate an auditing procedure that requires a search
for something that is not defined.

Let me ask, rhetorically, about enterprises that do not announce restructurings or
exit plans and consequently do not recognize liabilities related thereto early but
simply account for expenditures the “regular way” when liabilities arise under
contracts. Their financial statements presumably will be OK under generally
accepted accounting principles. Thus, allowing liabilities to be recognized based on
a management decision to recognize the liabilities would appear to result in non-
comparability among and between enterprises.

Finally, I think that we will continue to have definitional problems. What will
constitute a “restructuring?” What will constitute an “activity” that is planned to be
exited? I do not see ready answers for those questions.

108 ACCOUNTING FOR ASSETS AND LIABILITIES

Based on this analysis, I suggest that the liabilities to be recognized for
termination benefits, exit costs, and other costs said to be incurred in restructurings
are not liabilities but are in the nature of contingency reserves, which were
precluded by Accounting Research Bulletin 50, issued in 1958, and brought forward
by the FASB in Statement 5 in 1975.

We have all struggled together for almost a year now working on accounting for
restructurings. I hope my analysis—from the perspective of one who signed FASB
Statement 5—is useful and of interest to you.

MARK TO MARKET ACCOUNTING 109

11
Enforcement issues, and is the cost of

purchased goodwill an asset?
Speech to the Financial Accounting and Reporting Section, American

Accounting Association Annual Meeting, New Orleans, 17 August

1998

When Bob Swieringa called several months ago and asked me to speak here today, he
suggested that I talk about some of the financial accounting and reporting issues
that I see on the enforcement side of the Securities and Exchange Commission and
about my views on accounting for intangible assets.

First to enforcement. There is nothing new under the sun on the accounting side
at the Enforcement Division. Over the years, I have heard every chief accountant of
the division speak at forums like this one, and they have all said the same things. I
have been the chief accountant of the Enforcement Division since November 1997,
and I have seen nothing new except that some of the frauds are now on the
Internet. There are only so many ways to cook the books. I too am going to sound
like a broken record.

Let me illustrate the kind of problems that we accountants in the Enforcement
Division actually work on. In the nine months that I have had to look at the
problems since I became chief accountant, I see that we do not deal much with
esoteric accounting problems such as foreign currency translation or the ins and
outs of pension accounting or post-pre-retirement benefits other than pensions. We
deal with more pedestrian issues.

Premature revenue recognition appears to be the first choice for cooking the
books. Recognizing revenue in advance of the customer’s acceptance of the product.
Recognizing revenue when right of return exists. Shipping product to company
warehouses and employees’ homes and recognizing sales revenue. Keeping the sales
journal open after the end of the quarter or year but back-dating sales invoices.

Recognizing officers’ salaries as receivables. Recognizing cash taken from the
corporation by officers as cash in bank, or as an investment, or as a direct reduction
of stockholders’ equity instead of as a charge to expense. Bleeding into income,
without disclosure, “reserves” established in business combinations or in so-called
restructurings. In some recent cases, the bleeding has turned into hemorrhaging.

I thought that the “reserve” issue had been resolved in 1975 when the Financial
Accounting Standards Board issued Statement 5 on “Accounting for
Contingencies.” But I have found that reserves are like crab grass. They are
everywhere. Tax liability cushions. Deferred tax asset cushions. Inventory reserves.
Bad debt reserves. Merger reserves. Restructuring reserves. They are everywhere.
The Division of Corporation Finance, in its reviews of filings by issuers, sprays
Roundup on issuers’ balance sheets, but the crab grass reserves keep re-emerging.
(For you apartment dwellers, Roundup is a herbicide that is supposed to kill weeds.)
The reserves are being used to manipulate earnings. Need a penny a share to meet
Wall Street’s expectations? Need two pennies? A nickel? A dime? Two bits? Dip into
the chocolate chip cookie jar reserve. The mere existence of reserves is a chocolate
chip cookie jar that management cannot resist when the earnings need a sugar high.
We need to fix reserve accounting. It’s time to make another pass at reserves; we
need a Year 2000 version of FASB Statement 5.

How about treasury stock carried as an asset in the balance sheet at market, with
“unrealized” gains credited to unearned income and “realized” gains on sale of the
treasury stock credited to income. I’m not making this up. How about increasing
fixed assets and crediting cost of sales. Not booking all of the accounts payable; just
put the invoices from suppliers into a desk drawer. Not writing down or writing off
uncollectible receivables. Booking barter trade credits as if they represented US
dollars. Such is the grist of our accounting mill. Not very esoteric stuff. If I draw an
analogy with police work, what we see is stolen automobiles with fingerprints on the
door handles, not murders where there are no clues except for dogs that did not
bark.

On the audit side, I have now seen several non-audits since I came on board last
year. Auditors accepting, with little or no evidential support, values ascribed to both
monetary and non-monetary assets. Artwork by unknown artists booked as assets at
huge amounts but without any support for the assigned value or no inquiry by the
auditor about independent valuation of the artwork. Receivables acquired from
collection agencies for pennies but booked at dollars without any documentation
and no auditor inquiry as to the basis for the value. Auditors not doing substantive
audit work but relying on so-called analytical procedures where the evidence, or lack
thereof, cries out for substantive audit work. Auditors not doing cut-off work for
sales and purchases. And, of course, we see cases where the auditors were lied to or
were not given all of the documentation that they should have been given. But
sometimes I wonder whether the auditors asked the right questions.

Now, on to intangibles, and specifically whether the cost of goodwill is
recognizable as an asset. The FASB has on its agenda the broad question of
accounting for business combinations and what to do about the cost of purchased

ACCOUNTING FOR ASSETS AND LIABILITIES 111

goodwill. The board has tentatively concluded that the cost of purchased goodwill is
an asset—that it meets the board’s definition of an asset in its Statement of Financial
Accounting Concepts No. 6, Elements of Financial Statements, which I will refer to
as Concepts Statement 6. Presumably, the board has also concluded that the cost of
goodwill has all of the necessary characteristics to constitute an asset and that the
measurement criterion is met although I am not sure that the board has had a
thorough-going discussion about measurement.

In articles and speeches in 1991 (“Keep it simple,” Accounting Horizons 1991, pp.
113–17) and 1993 (“What is an asset?” Accounting Horizons, September 1993, pp.
66–70), I proposed that accountants use as a definition of an asset the following:
“Cash, contractual claims to cash, and things that can be sold separately for cash.” I
proposed that exchangeability be a required feature of anything recognized as an
asset in a balance sheet. Under my proposal, the cost of goodwill would not qualify
as an asset. The Financial Accounting Standards Board has not adopted those
proposals, however. Thus, in addressing the question of whether the cost of
goodwill should be recognized as an asset, I will use the FASB’s definition in its
Concepts Statement 6, namely, “Assets are probable future economic benefits
obtained or controlled by a particular entity as a result of past transactions or
events” and the board’s enumerated characteristics of assets. Exchangeability is not a
required feature of an asset in the board’s conceptual framework.

The basis for the board’s tentative decision is, as I understand it, as follows, in
highly summarized form: (1) while the cost of goodwill itself lacks the capacity to
generate future net cash inflows, it has the capacity in combination with other assets
to contribute indirectly to those cash flows and therefore meets the “future
economic benefit” test; (2) control over the cost of goodwill is provided by the
acquirer’s controlling financial interest in the acquired entity’s equity or equity
securities; and (3) the cost of goodwill obviously arises from a past transaction,
which is the third condition in the definition. I do not agree with the board’s
analysis. I think that the analysis omits too much.

The board’s articulation, in Concepts Statement 6, of the necessary characteristics
of an asset says that (1) it, whatever it is, must have a probable future economic
benefit, (2) a cost, by itself, is not an asset, and (3) in order for something to be an asset
it must be controlled by the enterprise that calls the something its asset. I think that,
ultimately, the board will not be able to demonstrate convincingly and persuasively
that the cost of purchased goodwill satisfies each and every one of those three
characteristics. I will explain why, using the board’s own words.

In paragraph 172 of Concepts Statement 6, the board said, “Future economic
benefit is the essence of an asset. An asset has the capacity to serve the entity by being
exchanged for something of value to the entity, by being used to produce something
of value to the entity, or by being used to settle its liabilities.” The cost of purchased
goodwill is simply the amount paid by one entity for the net assets of another
entity, or for a controlling equity interest in another entity, in excess of the fair
value of the individual, identifiable net assets (assets minus liabilities) of that other
entity; the amount said to represent the cost of purchased goodwill is just the excess

112 MARK TO MARKET ACCOUNTING

amount left over—in a word, the lump. But the lump cannot be exchanged for
anything. The lump cannot be used to produce anything of value. The lump cannot
be used to settle a liability. I conclude, therefore, using the board’s own words, that
the future economic benefit criterion has not been met.

In paragraph 179 of Concepts Statement 6, the board said, “Although an entity
normally incurs costs to acquire or use assets, costs incurred are not themselves
assets.” The lump is just a cost, nothing more. It is not the cost of something that
will, by itself or in combination with anything else, produce any identifiable positive
future cash inflow or reduce any identifiable future cash outflow—which is what a
future economic benefit is. As the board itself said, a cost is not an asset, so the lump
fails to be an asset by the board’s own words.

In paragraphs 183 and 184 of Concepts Statement 6, the board said, “To have an
asset, an entity must control future economic benefit to the extent that it can
benefit from the asset and generally can deny or regulate access to that benefit by
others, for example, by permitting access only at a price…The entity having an
asset…can exchange it, use it to produce goods or services, exact a price for others’
use of it, use it to settle liabilities, hold it, or perhaps distribute it to owners.” But
the lump cannot be exchanged for anything; it cannot be used to produce goods or
services; it cannot be leased or loaned to others for a price; it cannot be used to settle
liabilities; it cannot be held the way one holds, for example, land or patents or
marketable securities; and it cannot be distributed to owners. I conclude, therefore,
using the board’s own words, that the lump cannot be controlled.

Maybe my difference of opinion with the board represents a different view of
what the financial statements of operating companies should show versus what the
financial statements of investment companies should show.

There is no doubt, and I agree, that the owner of an investment in net assets, or
an interest in net assets, controls that investment. If the financial statements are to
show the investment, which investment implicitly includes the lump, and the results
of holding that investment, then the balance sheet will show a oneline item
representing the investment, perhaps at cost or perhaps at fair value, and the income
statement will show dividends flowing from the investment and perhaps changes in
the fair value of the investment, That is the way an investment, and the results of
holding an investment, are shown in the financial statements of an investment
company. In the financial statements of an operating company, however, the
investment is not portrayed; instead the individual operating assets such as
marketable securities, loans, inventory, land, plant, equipment, mines, and patents,
and the results of using or holding those individual operating assets, are portrayed,
for it is those individual operating assets that generate cash inflow, and only those
operating assets. It is in the balance sheet of an operating company that the lump
does not, in my opinion, satisfy the control criterion even though that criterion would
be met in the balance sheet of an investment company as to the investment itself.

There is a final question to ask about whether the cost of goodwill should be
recognized as an asset by an operating company, namely, whether there is reasonably
reliable measurability. Assume, arguendo, that, somehow, one can argue

ACCOUNTING FOR ASSETS AND LIABILITIES 113

convincingly that the cost of goodwill meets the definition of an asset. The problem
does not end there. The next and conclusive step is that the future economic benefit
from that asset be measurable, with reasonable reliability (see paragraphs 44–8 of
Concepts Statement 6). Even at the date of acquisition, the cost of goodwill is not a
reliable indicator of the value of any possible indirect future economic benefits. At
the date of acquisition, the cost of things such as raw materials, land, equipment,
computers, mines, and patents is approximately the amount that all market
participants have judged to be the appropriate cash price (laying aside the difference
between bid and ask prices). That cash price is the market participants’ collective
judgment about the future economic benefit (cash flows) embodied in the thing
that was acquired, and one can look to that marketplace for a reliable measure of
those benefits. Not so for the cost of goodwill, not even at the time of acquisition.
No one would pay anything for it alone. And, no business person would sign his or
her name to a purported appraisal value of goodwill standing alone. Thus the
measurability criterion has not been met.

If the cost of purchased goodwill is not an asset in the financial statements of an
operating company, whether because of definitional problems or measurement
issues, then what is it? The cost of purchased goodwill is not the distribution of an
asset (a dividend) to owners, which would be charged to equity. If the cost of
purchased goodwill is not an asset, as I have argued, and as the cost of purchased
goodwill is not a distribution of an asset to owners that would be charged to equity,
the cost of purchased goodwill then must represent an expense at the time the cost
is incurred. The cost of purchased goodwill is like other costs that are not assets
under the board’s definition of an asset: advertising new or existing products or
services, recruiting employees, training new employees, training or retraining
existing employees, scouting new locations, opening new stores, starting a new line
of business, restructuring an existing business, writing software code to fix the Year
2000 problem, and researching possible new drugs, to name only a few; all such
costs, not being assets under the board’s definition of an asset, are charged to
expense.

114 MARK TO MARKET ACCOUNTING

12
Cookie jar reserves

Speech delivered at the Nineteenth Annual Ray Garrett Jr Corporate

and Securities Law Institute, Corporate Counsel Center of

Northwestern University School of Law, 22 April 1999

One of the accounting “hot spots” that we are considering this morning is
accounting for restructuring charges and restructuring reserves. A better title would
be accounting for general reserves, contingency reserves, rainy day reserves, or
cookie jar reserves.

Accounting for so-called restructurings has become an art form. Some companies
like the idea so much that they establish restructuring reserves every year. Why not?
Analysts seem to like the idea of recognizing as a liability today, a budget of
expenditures planned for the next year or next several years in down-sizing, right-
sizing, or improving operations, and portraying that amount as a special, below-the-
line charge in the current period’s income statement. This year’s earnings are
happily reported in press releases as “before charges.” CNBC analysts and
commentators talk about earnings “before charges.” The financial press talks about
earnings “before special charges.” Funny, no one talks about earnings before credits
—only charges. It’s as if special charges aren’t real. Out of sight, out of mind.

The occasion of a merger also spawns the wholesale establishment of restructuring
or merger reserves. The ingredients of the merger reserves and merger charges look
like the makings of sausages. In the Enforcement Division, I have seen all manner
and kind of things that ordinarily would be charged to operating earnings instead
being charged “below the line.” Write-offs of the carrying amounts of bad
receivables. Write-offs of cost of obsolete inventory. Write-downs of plant and
equipment costs, which, miraculously at the date of the merger, become non-
recoverable, whereas those same costs were considered recoverable the day before the
merger. Write-offs of previously capitalized costs such as goodwill, which all of a
sudden are not recoverable because of a merger. Adjustments to bring warranty
liabilities up to snuff. Adjustments to bring claim liabilities into line with
management’s new view of settling or litigating cases. Adjustments to bring
environmental liabilities up to snuff or into line with management’s new view of the
manner in which the company’s obligations to comply with the EPA will be

satisfied. Recognition of liabilities to pay for future services by investment bankers,
accountants, and lawyers. Recognition of liabilities for officers’ special bonuses.
Recognition of liabilities for moving people. For training people. For training
people not yet hired. For retraining people. Recognition of liabilities for moving
costs and refurbishing costs. Recognition of liabilities for new software that may be
acquired or written, for ultimate sale to others. Or some liabilities that go by the
title of “other.”

It is no wonder that investors and analysts are complaining about the credibility
of the numbers. A bank stock analyst was quoted in the WSFs “Heard on the street”
on 1 April: “The reported profits number is now considered an accounting fiction.”
Warren Buffett’s latest annual report to shareholders of Berkshire Hathaway has
several pages of commentary about restructuring and merger reserves. He says that
“many managements purposefully work at manipulating numbers and deceiving
investors…when it comes to restructurings and merger accounting.” A major
investment banking house has concluded that the P/E ratios of stocks and indexes
of stocks are understated because of restruc turing charges and merger charges being
“below the line”; that, for example, the P/E of the S&P 500, instead of being, say,
31 should really be 34 or 35 because the special charges are not factored into the
earnings part of the calculation.

The cover for these shenanigans is two “consensuses” of the FASB’s Emerging
Issues Task Force that deal with recognition of liabilities on the occasion of a
restructuring or a merger, namely EITF 94–3 and 95–3. Generally, what EITF 94–
3 permits is (1) the recognition as a liability today of future expenditures for
involuntary termination benefits to be paid to employees and (2) the recognition of
a liability today for future expenditures that are directly associated with a plan to
exit an activity—provided those expenditures will have no future economic benefit
and provided four conditions laid down by the EITF are met. EITF 95–3 expands
on 94–3 to say that, in a business combination, expenditures to relocate employees
may also be recognized as a liability at the time of the business combination, in
addition to the employee termination benefits and exit costs covered by 94–3.

Those two utterances by the Emerging Issues Task Force allow for the
recognition of liabilities based on a representation by management that the
company will make certain expenditures but before a cash outflow is required
pursuant to a law or a contract In all other cases except in the accounting for
pensions and OPEBs, liabilities are not recognized until some event has occurred
and a cash outflow is therefore required, either by law or regulation or under an
enforceable contract. For example, liabilities to suppliers of goods are not booked by
the buyer until the supplier has delivered the goods to the buyer. Liabilities for
salaries and wages are not booked until employees have worked and earned their
pay. Liabilities for tomorrow’s rent and electric are not booked until the premises
have been used and the electricity has been used—both events of the tomorrow, not
today. There is no liability to pay investment bankers, accountants, or lawyers until
they have performed services. But, pursuant to the EITF pronouncements, it is OK
to recognize a liability today for severance pay to employees that will be paid to them

116 ACCOUNTING FOR ASSETS AND LIABILITIES

months or years in the future but only if they stay at their jobs until then. It’s OK to
recognize a liability today for other so-called “exit costs.” It’s OK to recognize a
liability today for future costs that will have no future economic benefit. But,
because the EITF could not define a restructuring, and therefore could not specify
its ingredients, those two consensuses are, as a practical matter, largely optional. For
example, looking at the Forbes article of 23 March 1998 on “Pick a number, any
number,” two of the companies interviewed, VF Corporation and Walgreen, said that
they do not recognize restructuring charges, whereas many companies do. VF
charged the $400 million cost of cutting 2,000 jobs and consolidating seventeen
locations to five to current earnings instead of as a restructuring charge. Walgreen
charged the cost of closing 400 stores over five years to current earnings instead of as
restructuring charges. VF’s CFO is quoted as saying, “Restructuring is an invention
by Wall Street. It’s a term for covering up debits. We don’t play that game. It’s
short-sighted, It delays the inevitable.” Jack Ciesielski, a CPA/analyst with
R.G.Associates, in the 29 March 1999 issue of The Analyst’s Accounting Observer, in
footnote 8, says that following the consensuses is optional. Thus, Company A may
establish a restructuring reserve and charge selected expenditures to that reserve if it
wants to, but Company B need not establish such a reserve and may charge the
expenditures to income in the regular way—even though both may be similarly
situated and have the same auditors. Or both Company A and Company B may
establish reserves for some restructurings but not others. To boot, the numbers
ascribed to restructurings and thus included in the reserves cannot be verified by the
outside auditor by reference to anything except management’s assertion, which is no
evidence or verification at all; the numbers are whatever management of the
enterprise says they are. Moreover, I have seen the amounts of those initially
established reserves arbitrarily increased for good measure. These excessive amounts
of reserves are then leached, undisclosed, into subsequent operating income at a rate
that is under someone’s radar screen of materiality.

On the point about the inability to audit the numbers in these reserves, imagine a
situation where a new management team comes in after year end and dramatically
changes the amounts in various reserves established by the previous management.
The new management issues restated financial statements for the prior periods. The
same audit firm reports on both sets of financial statements without qualification. We
also see, quite frequently, where restructuring reserve amounts are retroactively
restated downward as a result of piercing, probing comment and inquiry by the
Division of Corporation Finance, and the external auditors report without
qualification on the financial statements with the reserve at its original amount and
at its revised, decreased amount. So much for auditing reserves.

I was chief accountant in 1994 when EITF 94–3 was debated by the Emerging
Issues Task Force. I pleaded with the EITF not to allow the recognition of liabilities
today where there has been no past event, for example the performance of services
by employees or the receipt of goods from suppliers or the receipt of cash in return
for issuing a put option, which establishes that the reporting enterprise has an
obligation to lay out cash tomorrow. I made a speech about that on 8 November

MARK TO MARKET ACCOUNTING 117

1994 to the Financial Executives Institute. As I recall, I sent a copy of that speech to
EITF members. In that speech, I pointed out the conceptual flaw in the EITF’s
approach and the practical consequences of that approach. Nine days later, on 17
November, despite my pleas, the Emerging Issues Task Force said OK to the
establishment of restructuring reserves.

What has happened since 1994? Well, my instinct in 1994 has been confirmed
by practice. What has happened since 1994 is that general reserves, contingency
reserves, rainy day reserves, and cookie jar reserves are now in vogue for those who
want to use them. Based on what I see in the Enforcement Division, apparently
there is almost no limit to what ingredient may be included in the reserves or the
amount ascribed to it. I was recently in a conversation with a prominent Wall Street
lawyer whose client established, improperly, a general contingency, rainy day reserve.
This lawyer explained his client’s rationale for the reserve that was established. I said
to the lawyer that his description of his client’s rationale was the description of a
general contingency reserve, which was outlawed by the FASB in 1975.
Whereupon, he called me a pencil pusher and said that all the Fortune 500
companies are doing the same thing his client did.

How does this problem get fixed? The FASB’s definition of a liability in its
Concepts Statement 6 says, in footnote 22, that “It [a liability] includes equitable
and constructive obligations as well as legal obligations.” The question is what
constitutes a constructive obligation? Does an announcement by a company that it
will lay off 100 or 1,000 employees create a liability for termination bonuses that are
promised to be paid at termination but only if the employee remains as an employee
until terminated by the company? Does a decision by a lessee that it will no longer
use leased facilities give rise to a recognizable liability for the lease payments when
there was no recognizable liability the day before the decision? The accounting for
pensions and OPEBs is based on an idea of a constructive obligation, not on a
vested-benefit notion, which is more akin to a legal obligation. Are management
decisions, which obviously are always reversible, to terminate employees and no
longer use facilities sufficient to either permit or require the recognition of liabilities
before the obligation to pay cash becomes an obligation enforceable at law? The
FASB has been working on such questions in three projects that it has on its
agenda, namely, liabilities and equity, obligations associated with the retirement of
long-lived assets, and impairment and asset disposal issues. It appears that the
questions are very, very difficult. Getting agreement apparently is not easy. The SEC
staff has been encouraging the FASB to complete work on these projects. Investors
urgently need some guidance that can be applied uniformly by all issuers and their
auditors so that investors receive better information and can make more informed
decisions.

Meanwhile, however, the Division of Corporation Finance and the Office of the
Chief Accountant are taking a close look at restructuring reserves and merger
reserves. So is the Enforcement Division. I am going to take a pencil pusher’s
attitude to all such reserves and examine whether all of the ingredients of an issuer’s
reserve are explicitly permitted by the words in EITF 94–3 and 95– 3 and the issuer

118 ACCOUNTING FOR ASSETS AND LIABILITIES

has explicitly and in detail justified the reserve and the amount thereof and
documented that justification.

If you have clients that have established restructuring reserves or merger reserves,
I recommend that you and the audit committee get for yourselves copies of EITF
94–3 and 95–3, get your client’s CFO and CEO into a conference room, and you
and the audit committee do your own audit of the restructuring reserves and
determine whether what your client has done fits into the authoritative literature.

MARK TO MARKET ACCOUNTING 119

13
Financial instruments

In 1992, I requested a copy of the attached letter of 13 February 1986 from me to
the FASB regarding financial instruments (I had lost my copy of the letter). Halsey
Bullen, one of the FASB’s senior staff, sent the letter to me with a handwritten note
as follows:

Here is the letter you wanted. I’m not sure how much credit we gave you at
the time, but it was this letter that led to our [FASB] Statement 105
[Disclosure of Information about Financial Instruments with Off-Balance-
Sheet Risk and Financial Instruments with Concentrations of Credit Risk]
and Statement 107 [Disclosure about Fair Value of Financial Instruments].

Halsey Bullen 10–16–92.

Peat, Marwick, Mitchell & Co.
Certified Public Accountants

345 Park Avenue
New York, NY 10154

13 February 1986

Mr Halsey G.Bullen
Financial Accounting Standards Board

P.O. Box 3821
High Ridge Park

Stamford, CT 06905–0821

Dear Mr Bullen,
This letter is a follow-on to the meeting on February 5, 1986 at the FASB to

discuss the scope of a possible Board project(s) on “Financial Instruments.”
While I believe that a Board project is necessary, particularly in response to Mr

Sampson’s letter of June 1985 to Mr Kirk, I did not find the scope of the Board’s
project defined very clearly in the materials accompanying your letters of January 27

and 31, 1986. I am very much inclined to a different initial approach than where
you appear to be headed, viz., disclosure of market values of on- and off-balance-
sheet financial instruments. (I agree with Mr Stewart that FAS 76 and 77 and FTB
85–2 need to be re-examined; they produce illogical, and sometimes inexplicable,
results.)

Assets represented by financial instruments generally are reported at cost, not at
market value. There are exceptions in FASB pronouncements: for example, FAS 12,
market or lower of cost or market for marketable equity securities; FAS 52, market
for foreign currency; FAS 60, market for common and non-redeemable preferred
stocks; and FAS 65, lower of cost or market for inventory. Certain AICPA Industry
Guides require certain assets to be reported at market; for example, the Broker/
Dealer and Investment Company Guides for practically all assets and the Bank
Guide for trading account securities. And the Bank and Savings and Loan Guides
require disclosure of market value for investment account securities. But there is no
single, across-the-board requirement to disclose market values of assets that readily
can be, and in many cases are, bought and sold.

In the end, the Board will have to deal with when and which assets represented by
financial instruments should be reported at market value in the basic financial
statements. This is the “fundamental question” raised by Mr Sampson, or at least
one of them. Before the Board can make an informed decision on the when and
which questions, however, I think that the Board and its constituencies need
information about (1) how difficult it is, if it is, to find market values for financial
instruments that are not traded on exchanges or in a highly organized over-the-
counter market and (2) how people would react to the introduction of market
values of assets represented by financial instruments in the reporting of assets,
equity, and income.

The first step essentially involves fact finding and should be a relatively simple
task. The second step has to do with finding out about people’s emotions and their
perceptions of “economic reality.” For the Board to find out about those things—
those non-facts will require some period of introduction, aequaintance, and
education. Both of these steps can best be done through mandated disclosure before
introducing more market values into the basic financial statements, if that is the
Board’s decision.

As I said at the meeting, I would start with disclosure of market values for all on-
balance-sheet assets representing financial instruments. Next, I would proceed to
those financial instruments that currently are not shown on balance sheets and that
are used to hedge, shift risks to others, take on risks of others, and, in some cases, to
speculate.

As I also mentioned at the meeting, it was necessary for me to prepare a definition

ACCOUNTING FOR ASSETS AND LIABILITIES 121

Walter Schuetze

cc: Members of 2647 Task Force
Laurel Bond—SEC

Appendix A

Financial instruments

1 A contract, whether firm or optional, whereunder the issuer thereof has agreed
to deliver to the holder thereof, on a specified date(s):

a a specified amount of money (a money obligation on the part of the issuer of
the contract),

b a specified measure of a specified commodity (a commodity obligation on
the part of the issuer of the contract), or

c an uncertain amount of money with the final amount to be measured by
reference to an independently determined interest rate, price of a
commodity, including foreign money, or an index (an uncertain money/
commodity/index obligation on the part of the issuer of the contract).

2 In order for a commodity to fall within the scope of this project, a fairly ready
market must exist for it. Contracts involving the following are excluded:

a personal services,
b equipment,
c real estate (land and attachments to land, e.g. buildings),
d intangibles such as copyrights, patents, names, and franchises,
e minerals,
f air and water rights.

The aim would be to exclude specifically those that the Board would want to
exclude; b—f might be included if they serve as collateral for other contracts.

3 Included in the scope of this project would be any item for which one can find
price or yield quotations in financial or trade publications or as to which
brokers and offer price or yield quotations. (The aim here would be to embrace
in the project(s) things for which a fairly ready market exists.)

4 Contracts requiring payments of cash or the use of other assets by the issuer
(writer) of the contract because of damages to life, health, or property or

122 MARK TO MARKET ACCOUNTING

of financial instruments that I had in mind. That definition is attached as Appendix
A.

Yours truly,

5 Admittedly, this kind of definition (paragraphs 1–4) has some ambiguity, but
the ambiguity would appear to be at a tolerable level.

ACCOUNTING FOR ASSETS AND LIABILITIES 123

damages arising from torts, errors or omissions, and business interruption
somehow should be excluded. Contracts relating to the performance of another
party under a contract should be included, however.

14
Accounting for transfers of receivables (by Tom,

Dick, and Harry)

When Walter Schuetze was appointed chief accountant to the Securities and
Exchange Commission in January 1992, he withdrew this article, which he had
submitted to the Journal of Accountancy in December 1991.

Peat Marwick
Certified Public Accountants

767 Fifth Avenue
New York, NY 10153

9 December 1991

Ms Barbara J.Shildneck
Executive Editor

Journal of Accountancy
1211 Avenue of the Americas

New York, New York 10036–8775

Dear Ms Shildneck,
I enclose an article on transfers of receivables (draft 12/9/91) that I would like

you to consider for publication in the Journal.
Because the issue is so hot and topical right now (the IASC has requested

comments on its exposure draft on financial instruments by the end of next May,
and the FASB has just issued its discussion memorandum on financial instruments),
I would like to get the article published very soon.

Please telephone me at 212–909–5644 to discuss.

Yours truly,
Walter Schuetze

Governments and regulators around the world are forcing banks to decrease their
leverage or increase their equity (capital). Thrifts in the United States must do the
same. Other enterprises such as insurers, retailers, and manufacturers want to reduce

their leverage or increase their equity (capital) so that they will be perceived as better
risks by those who lend money to them or invest in their stock, bonds, notes, and
commercial paper, or buy insurance from them. The entire world is in a liquidity
crunch, and all enterprises are competing in the worldwide marketplace to reduce
leverage or raise equity. Just-in-time inventory controls are one response to that
liquidity crunch. Another response is to sell receivables. All of these entities want
and need to get receivables—consumer loans, automobile loans, retail receivables,
mortgage loans, commercial loans, HLT loans, LDC loans, real estate loans,
agricultural loans—off their balance sheets. Thus, accounting for receivables, and
especially transfers of receivables, is hugely important.

Accounting for transfers of receivables in the United States is governed by
Statement of Financial Accounting Standards No. 77, Transfers of Receivables with
Recourse. It is one of the most controversial standards issued by the Financial
Accounting Standards Board. Why? Because the financial statement results
produced by following Statement 77 are counterintuitive. Because people do not
understand, and therefore are bewildered by, the financial statement results
produced by the statement. Because Statement 77 generally allows for sale
accounting when receivables are transferred and certain risks related to the
receivables are retained, but, at the same time, the statement does not require
recognition and measurement of those retained risks in a meaningful way. In fact,
under Statement 77, certain retained risks are not recognized at all by the transferor.
Under Statement 77, originators of receivables are able to sell those receivables and
report a gain—or no loss—retain certain risks inherent in the receivables, and not
recognize and portray the value of those risks on their balance sheets. Gain may be
recognized for accounting purposes when no economic gain exists. What accounting
magic. Cut off the end of a blanket, sew it to the other end, and the blanket is longer
than it was. Sadly, everyone who is a party to such a transaction—and the financial
community as a whole—knows there is no gain.

The controversy about Statement 77—and the financial stakes surrounding it —
are so great that a legion of Wall Street investment bankers, lawyers, and
accountants makes a handsome living figuring out how banks, thrifts, insurers,
retailers, and manufacturers can get receivables off their balance sheets without
recognizing losses in the process. Statement 77 is broken and needs to be fixed. It is
being reconsidered by the FASB in its Financial Instruments Project, but reso lution
is a long way off. Many accountants, maybe most accountants, would fix Statement
77 by not permitting sale accounting on transfers of receivables if the transferor
retains credit, interest rate, or foreign exchange risk. They would have the transferor
account for the transfer as a borrowing instead of a sale. I disagree with that
approach. It rejects what is right about the statement and ignores what needs
correction, as will be illustrated, and it results in the recognition of phantom assets
and liabilities. The FASB considered that approach in Statement 77 and rejected it.
The FASB decided instead that control over a receivable should drive the
accounting, not retention of risk. I agree with the FASB. However, Statement 77

MARK TO MARKET ACCOUNTING 125

needs to be modified so that risks retained by the transferor are adequately
recognized in the transferor’s financial statements.

The International Accounting Standards Committee recently (September 1991)
issued an exposure draft of an International Accounting Standard1 on accounting
for receivables and transfers of receivables that would, if adopted by the IASC and
then by the FASB in the spirit of international harmonization, put the accounting
for receivables, and especially transfers of receivables, back into the Dark Ages.2

The IASC’s proposal is based on accounting for risks and rewards inherent in
receivables, not who controls the receivables. According to paragraphs 19 and 20 of
E40, a receivable3 has the following risks and rewards:

19 Financial instruments (receivables] result in an enterprise assuming or
transferring to another party one or more of the financial risks described below.

Price risk

There are three types of price risk: currency risk, interest rate risk, and market risk.
Currency risk is the risk that the value of a financial instrument will fluctuate due to
changes in foreign exchange rates. Interest rate risk is the risk that the value of a
financial instrument will fluctuate due to changes in market interest rates. Market
risk is the risk that the value of a financial instrument will fluctuate as a result of
changes in market prices, whether those changes are caused by factors specific to the
individual security or its issuer or factors affecting all securities traded in the market.
The term “price risk” embodies not only the potential for loss but also the potential
for gain.

Credit risk

Credit risk is the risk that one party to a financial instrument will fail to discharge
an obligation and cause the other party to incur a financial loss.

Liquidity risk

Liquidity risk is the risk that an enterprise will encounter difficulty in raising funds
at short notice to meet commitments associated with financial instruments (also
referred to as funding risk). Liquidity risk may result from an inability to sell a financial
asset quickly at close to its fair value.

Changes in the market’s perception of these risks give rise to fluctuations in the
market price of a financial instrument. For example, the market price of a debt
security is affected by changes in the market’s perception of credit risk, as well as by
changes in market interest rates and, in some cases, currency risk.

20 The rewards associated with a financial asset may include not only potential
gains as a result of having assumed price risk but also rights to receive interest

126 ACCOUNTING FOR ASSETS AND LIABILITIES

and payments of principal, to pledge the instrument as security for obligations,
to dispose of the instrument for consideration and to use the instrument to
settle an obligation. Financial liabilities usually arise from transactions in which
the enterprise has received some past benefit, such as a receipt of cash, and may
also have the potential for future benefits as a result of exposure to price risk.

The IASC proposes, in E40:

1 An enterprise initially should recognize a receivable (a financial asset) when the
risks and rewards associated with the receivable have been transferred to the
[reporting] enterprise [paragraph 15]. [What curious words. I do not
understand why the IASC used the phrase “transferred to.” “Acquired by”
would have been a more conventional and comfortable form of words.]

2 A receivable is not de-recognized—that is, a sale is not recognized—by the
transferor if the receivable is transferred to others in a manner that involves the
retention by the transferor of some of the original risks and rewards inherent in
the receivable [paragraphs 29 and 30). In that case, the proceeds of sale are
recognized as a liability by the transferor.

The IASC’s proposal on initial and subsequent recognition/de-recognition of a
receivable is based on whether the risks and rewards associated with the receivable
have been transferred to [acquired by] or retained by the reporting enterprise. I
think that initial and subsequent recognition/de-recognition of a receivable by an
enterprise should be based on control—that is, who has title to the receivable, who will
collect the cash proceeds from the debtor, who can sell/transfer the receivable or
parts of it to someone else, who can pledge the receivable, who can use the
receivable as collateral for a debt, who can forgive the receivable, and who can give
the receivable to charity. The IASC’s proposal would require the recognition of
phantom assets and liabilities.

Under the IASC’s proposal, if a bank originates a receivable, transfers it to
another party, and guarantees that the debtor will pay on time and in full as per the
receivable contract, then the bank would not de-recognize the receivable but would
account for the transfer as a borrowing. Whereas if an enterprise other than the
guaranteeing bank originates that same receivable and buys credit insurance from
the bank in the form of a letter of credit, then the bank would not recognize and
report the receivable as its asset. Yet, in both cases, the bank has exactly the same
risk. Not consistent, logical conclusions. Tilt. To describe a receivable, or any other
asset, in terms of its risks and rewards is oblique; describing it in terms of who has
control of it is direct. Deriving accounting results based on the idea of control has a
better chance of being consistent and logical.

What would be some of the consequences of the IASC’s proposal on transfers of
receivables if it were to be implemented?

MARK TO MARKET ACCOUNTING 127

1 If the originator/acquirer of a receivable—Tom—transfers (sells) the receivable
to Dick and Tom retains one of the risks described above, say, credit risk, then
Tom could not remove that receivable from his balance sheet But to Tom that
receivable is a phantom receivable after the transfer. Tom will not collect the
cash paid by the debtor, cannot sell the receivable again, cannot pledge the
receivable, cannot forgive the receivable, and cannot give it away. And if the
receivable that was sold is denominated in a foreign currency, then Tom would
have to report phantom foreign currency gains or losses. Tom’s hapless
treasurer might even hedge that phantom receivable with a real foreign
currency futures contract. What a thigh slapper that would be. How would
Tom mark to market a receivable he does not own and cannot sell?

Tom would have to recognize a liability equal to the proceeds received from Dick.
That presentation would imply that 100 percent of the receivables are bad or will go
bad, and Tom will have to pay back to Dick all of the cash Dick paid to Tom. That
implication is not in keeping with the facts; Dick would not buy receivables that are
totally bad or are going to go totally bad. The liability that Tom would report will
not require cash payments by Tom to Dick except to the extent that receivables go
bad. Thus the liability that Tom would have to report is a phantom liability.

Tom would have to report phantom revenue, expenses, cash receipts, and cash
payments related to the phantom receivable and liability. Tilt.

2 If Tom retained credit risk in the transfer and Dick acquired no credit risk,
then Dick, under the IASC’s proposal for recognition of a receivable (E40,
paragraph 15), would not report the transferred receivable as an asset; Dick
would report a receivable from Tom in the full amount of the price that Dick
paid Tom for the receivable. If you are Dick’s auditor, try to send a receivable
confirmation to Tom and see what Tom says. Tom will say that he does not
owe Dick any money. If Tom says that he does not owe Dick any money, how
then can Dick report a receivable from Tom? Double tilt.

3 If Dick needs or wants cash before the receivable is fully collected, Dick may
transfer the receivable, without recourse or guarantee, to Harry for cash. What
asset would Harry report: the receivable itself, a receivable from Dick, or a
receivable from Tom? I guess a receivable from Tom or Dick but not the
receivable itself. But Harry owns the receivable itself and will collect the cash
from the original debtor, not from Tom or Dick. Triple tilt.

Some may argue that the IASC’s proposal for accounting for the transfer of
receivables with recourse for credit loss is analogous to the accounting by a borrower
for collateralized borrowings.4 I disagree. A borrower who has pledged an asset that
he/she/it owns as collateral for a debt can regain unrestricted, unconditional control
of the pledged asset simply by extinguishing the debt. The transferor of a receivable
cannot do that; the transferee owns the receivable; the transferor cannot regain
control of the receivable unless the receivable goes bad. If the value of a pledged

128 ACCOUNTING FOR ASSETS AND LIABILITIES

asset goes up, the borrower/owner can benefit from that event. If the value of a
transferred receivable goes up, the transferee can benefit from that event, but the
transferor cannot benefit. If the value of a pledged asset goes down, the borrower/
owner suffers to the full extent. If the value of a transferred receivable goes down,
the transferor suffers only to the extent he/she/it must pay the transferee for some or
all of the decline under the contract surrounding the transfer. There are large,
important differences between collateralized borrowings and transfers of receivables
with retained risk for credit loss. The analogy is flawed.

As I said, Statement 77 is broken and needs to be fixed, but not along the lines of
the IASC’s proposals. The way Statement 77 needs to be fixed is to retain the notion
of control currently in Statement 77 and to go on to require recognition, at fair
value, of the risks and rewards retained by the transferor. This is, after all, how such
transactions are priced by transferors and transferees. If the seller/transferor retains
credit risk, then the seller should recognize, at fair value, the liability for the credit
put written by the seller. If the seller retains interest rate risk, then the seller should
recognize, at fair value, the liability for the interest rate put written by the seller. If
the seller retains foreign exchange risk, then the seller should recognize, at fair value,
the liability for the foreign exchange put written by the seller. Then, at each balance
sheet date, the seller should reprice these written puts to their fair value and
recognize that price change in income. The same goes for rewards; the seller should
recognize at fair value the rewards—the calls—retained by the seller.

Let me be up-front about my proposal on how to fix Statement 77. What would
be some of the consequences? Recognizing liabilities, at fair value, at the time of
transfer for written puts for credit risk, interest rate risk, or foreign exchange risk,
would significantly and dramatically reduce gains, or increase losses, on transfers of
receivables compared with the results that we get today under Statement 77.5 As it
now stands, Statement 77 requires no recognition of any liability whatsoever for
retained interest rate risk or retained foreign exchange risk. And it requires, with
respect to retained credit risk, that the recourse obligation be measured by reference
to FASB Statement 5. Statement 5, read in conjunction with Statement 77, is
confusing and has been interpreted in different ways. Statement 5 requires that
credit loss for receivables be recognized for those receivables that have gone bad, not
those that may go bad. No one would buy bad receivables; sellers’ written credit puts
relate to receivables that may go bad in the future. If one looks at the recourse
obligation as being related to receivables that will or may go bad—sort of like a
warranty obligation for parts on machinery and equipment that will or may break—
then one would measure the recourse obligation more appropriately and robustly.
But that kind of measurement ignores a profit margin on the guarantee and the
time value of money and does not get at the fair value of the written credit put.
Reference to Statement 5 to measure the recourse obligation has proved to be
unsatisfactory.

Determining fair values of put and call options that are retained by sellers of
receivables will require difficult, and sometimes highly judgmental, estimations.
But, such estimates now are made in the world of credit insurance and derivative

MARK TO MARKET ACCOUNTING 129

instruments; in fact, real transactions for cash between real enterprises are based on
such estimates. Such estimates are also made when businesses are acquired and
lump-sum purchase prices must be allocated. Fair values can be
estimated. Estimating those values and accounting for those puts and calls will be
better than subsuming losses in balance sheets, as is now done under Statement 77,
and dribbling those losses into income over time. Better to estimate and account for
something that is relevant—the puts and calls—than to report irrelevant and
potentially misleading phantom assets and liabilities. More importantly, it is
imperative that transferors of receivables who retain risks estimate, and constantly re-
estimate, the fair value of the retained risks so as to make intelligent decisions about
the business they are in, namely, risk guaranty.

Moreover, repricing written puts at every balance sheet date and including that
price change in income may make for increased earnings volatility.6 Reduced gains,
or increased losses, and perhaps earnings volatility will make it difficult for some to
accept this way of fixing Statement 77. But repricing is the best accounting measure
of the results of the guaranty business.

However, the other way to fix Statement 77 is the way the IASC proposes. That fix
will balloon transferors’ balance sheets, create phantom assets, liabilities, revenue,
expenses, and phantom cash receipts and payments in statements of cash flows.
Reporting phantom assets and liabilities will cause ROAs around the world to
decline. If bank regulators in the United States and other countries that signed the
Basel Accord somehow believe that the phantom assets and liabilities are real, then
they may require that $8 of equity be raised for every additional $100 of assets that
will arise under the IASC’s proposals.7 If rating agencies somehow believe that the
phantom assets and liabilities are real, those rating agencies will downgrade debt
issued by highly leveraged enterprises. Investors and creditors will certainly be
confused and may be misled. Only accountants will know how to interpret the
financial statements under the IASC’s proposals, but they do not use financial
statements or make investment or credit decisions.

Notes

1 International Accounting Standard, proposed statement, “Financial instruments,”
Exposure Draft 40 (E40).

2 The Canadian Institute of Chartered Accountants also recently issued a proposal on
accounting for financial instruments and transfers of receivables very similar to the
IASC’s. The United Kingdom’s Accounting Standards Board also recently issued a
proposal on “securitisations.” The accounting proposed by the UK ASB for
securitisations is roughly the same as that proposed by the IASC for transfers of
receivables.

3 Under the IASC’s proposal, “receivables” include trade accounts receivable, notes
receivable, loans receivable, and bonds receivable, that is, a contractual right to receive
cash in the future (E40, paragraph A3).

130 ACCOUNTING FOR ASSETS AND LIABILITIES

4 Two members of the FASB, Messrs March and Sprouse, so argued in their dissents to
Statement 77. In Statement of Position 74–6, “Recognition of profit on sales of
receivables with recourse,” the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants stated, in paragraph 41, that “Sales
of receivables with recourse have significant characteristics of financing transactions in
which monies are borrowed and assets are pledged as security thereon.” In Statement of
Position 74–6, the Accounting Standards Executive Committee considered and
rejected the proposal that I advance in this article for retained credit risk; the
committee believed that the value of the written credit put option could not be
determined objectively. Statement of Position 74–6 was superseded by Statement 77.

5 Gains would be reduced, or losses increased, because the buyers of receivables from
banks, thrifts, insurers, retailers, and manufacturers generally have a higher cost of
capital than do the sellers; or the buyers are types of enterprise or individual that
demand higher rates of return than do the owners of those enterprises that originate
receivables. More importantly, pricing the written puts by reference to fair value—for
example, what third parties would charge to write the puts—will significantly increase
the liabilities of sellers of receivables who retain various risks over what is done under
Statement 77.

6 But earnings “volatility” also results by charging income with losses arising from risk
retention when cash payments are made; the “volatility” simply will come in later
periods. The “volatility” does not go away.

7 If a transferor bank retains risk, US banking regulators’ call report instructions are like
the IASC’s proposals in that the transferred receivable is not de-recognized, and those
regulators require $8 of equity for each $ 100 of phantom assets. I would argue that
regulators should base equity (capital) requirements on the fair value of the written
put liability, which in some cases might be more than $8 on $100. If the regulators
think that the amount of the put liability is too low or too high, they should adjust
that liability for their purposes and not force banks to recognize and report phantom
assets and liabilities.

MARK TO MARKET ACCOUNTING 131

15
Discount rate re cash outflows for nuclear

decommissioning and environmental
remediation

Director of Research and Technical Activities
Financial Accounting Standards Board

407 Merritt 7
P.O. Box 5116

Norwalk, CT 06856–5116
25 September 1995

Dear Sir,
Discount Rate re Cash Outflows for Nuclear Decommissioning and

Environmental Remediation
According to its Status Report 151-A of 7 July 1995, The Financial Accounting

Standards Board tentatively has concluded that cash outflows for nuclear
decommissioning should be discounted at a rate consistent with that specified in
FASB Statement 106 for cash outflows for retirees’ healthcare benefits, namely, the
rate of return on high-quality fixed-income investments or the settlement rate if
settlement is possible (Statement 106, paragraph 31). Settlement for post-retirement
healthcare benefits generally is not possible, so the settlement rate is not used.

The American Institute of Certified Public Accountants’ Accounting Standards
Executive Committee, on the other hand, in its 30 June 1995 exposure draft of a
proposed statement of position on environmental remediation liabilities, would
require that cash outflows be discounted at “a rate that will produce an amount at
which the environmental liability theoretically could be settled in an arm’s-length
transaction with a third party and that should not exceed the interest rate on
monetary assets that are essentially risk free and have maturities comparable to that
of the liability” (paragraph B30).

I suggest that the ASEC selected the correct rate for cash outflows related to
environmental liabilities and that the FASB should reconsider the rate for nuclear

decommissioning liabilities. Otherwise, those liabilities, especially those with long
payouts, will be significantly understated.

The objective should be to recognize and measure liabilities at their fair value When
money is borrowed, the fair value of the liability is the amount of money received
from the lender, and the rate charged by the lender, either explicit or implicit, is
known or may be calculated. In the absence of a borrowing and a schedule of
contractually fixed cash outflows, estimating the fair value of a liability is a
theoretical undertaking; it is made even more theoretical if there is no market in
which liabilities such as the one being recognized and measured can be settled. If
there were such a market, however, we could deduce how participants in that
marketplace would price future cash outflows for things such as environmental
remediation, nuclear decommissioning, post-retirement healthcare benefits,
pensions, and warranties. In that marketplace, participants first would estimate
future cash flows based on best estimates; then they would increase the amount of
best estimate for the risk of having made an incorrect estimate (adverse deviation);
and then they would make assumptions about investing the cash proceeds to be
received on the transfer of a liability. Inasmuch as neither the FASB nor the ASEC
allows for estimates of cash outflows for nuclear decommissioning or environmental
remediation to include a factor for adverse deviation, the estimate of total cash
outflows as allowed by the FASB and ASEC does not mimic what marketplace
participants would do, and therefore understates the liability in the first instance.
That understatement is compounded by using too high a rate for discounting the
future cash outflows.

Assume that one could know exactly both the timing and amount of cash outflows
for remediation or decommissioning. What amount of money would any transferee
demand to take on those cash outflows: that amount which if invested in risk-free
instruments (US Treasury securities in the United States) would exactly equal the
cash outflows to be made for remediation or decommissioning. Why is that? It is
because the transferee, if it is required, come hell or high water, to satisfy the cash
outflow requirements, would not, indeed could not, take on credit risk or any other
investment risk.

One can analyze the issue from a slightly different perspective. Assume again that
both the timing and amount of cash outflows for decommissioning or remediation
are known—exactly. Assume further that laws of the state allow for legal defeasance
of the future cash outflows by the obligor’s placing in trust today an amount of cash
to satisfy the cash outflow when necessary. The state, and the state’s citizens, could
demand that cash sufficient to satisfy the cash outflow requirement—with no
investment whatsoever of that cash pending the cash outflow—be deposited with the
state. But that would not be equitable either as to the obligor or the citizens of the
state, for the investment earnings would then benefit only the citizens. The citizens
would, in equity, agree to receive today that amount of cash, which if invested in
risk-free investments, would satisfy the cash outflow requirements. (The state, or
any transferee, would also want a small, additional amount of cash for

MARK TO MARKET ACCOUNTING 133

administration, or handling, but I have ignored that amount here.) The state would
not take risk and thereby pass on to the citizenry through taxation any cash shortfall
caused by a credit loss.

The ASEC selected the correct rate.
This analysis and conclusion have implications for the measurement of other

liabilities for which there is no marketplace where one can look for pricing, for
example retirees’ pension and healthcare benefits and warranties. As well, the cash
outflows for those items should be discounted using the risk-free rate.

Yours truly,
Walter P.Schuetze

cc: Mr G.Michael Crooch
Mr Michael H.Sutton
Mr E.W.Trott

134 ACCOUNTING FOR ASSETS AND LIABILITIES

16
Discount rate for pension liabilities

Sir Bryan Carsberg responded to my note of 17 April 1997 (attached). I have lost
his note. As I recall, he took me to task for my faulty thinking, and he argued to me
that a pension liability should be discounted taking into account the credit standing
of the employer/obligor. Largely based on Carsberg’s argument, I have changed my
mind. I now think that a vested pension liability should be measured by reference to
the amount of cash that the pensioner would accept in complete settlement of his/
her claim against the employer/obligor. The pensioner no doubt would take into
account the credit standing of the obligor.

Many pension benefits in the USA are guaranteed by the US federal government.
In that case, the credit standing of the employer/obligor effectively is that of the US
federal government; thus, the discount rate effectively would be the risk-free rate for
those vested pension liabilities.

I do not recall whether Carsberg’s argument in his note to me ran only to a vested
pension liability. And I do not know whether Carsberg would agree with my revised
thinking regarding the measurement of a vested pension liability.

17 April 1997
TO: Sir Bryan Carsberg, IASC
FROM: Walter P Schuetze
RE: Discount rate for pension liabilities
I read with great interest the exchange between McGeachin/Whittington (Team

1) and Metcalf/Peirson/Upton (Team 2) in the March 1997 issue of IASC Insight.
Team 1 argues for a “risk-adjusted rate” for discounting pension liabilities, while
Team 2 argues for the “risk-free rate.” In my opinion, Team 2 wins the argument
hands down.

But Team 2 did not go far enough. Team 2 argues for using the rate derived from
high-quality, fixed-rate corporate bonds. That is the same rate used by the Financial
Accounting Standards Board in its Statements 87 and 106. That rate includes some
factor, perhaps small, for credit risk, and using that rate will understate the amount

of the pension liability in relation to its fair value. (That rate may also include some
factor for coupon reinvestment risk.)

What is the fair value of a pension liability? It is the amount of cash the employer
would have to pay to a third party to assume the pension obligation. If that third
party must pay the pensioner, come hell or high water, the amount due the
pensioner under the pension contract, the third party will be unwilling to take any
credit risk (or reinvestment risk) whatsoever. So the rate that should be used is the
rate available on zero coupon bonds, or bonds stripped of their coupons, issued by
the sovereign state, which bonds will mature at the same time, and in the same
amount, as money must be paid to pensioners. (Of course, that third party would
want to be paid for its administrative costs plus some profit for its effort, but I have
ignored those matters here, although those amounts might not be trivial.)

Attached is a copy of my letter of 25 September 1995 to the FASB, wherein I
argued at more length about using the risk-free rate to discount certain liabilities.

136 MARK TO MARKET ACCOUNTING

17
Exposure Draft E55: Impairment of Assets

TO: The Secretary General, International Accounting Standards Committee
FROM: Walter P.Schuetze
RE: Exposure Draft E55: Impairment of Assets
DATE: 23 July 1997
The Exposure Draft on Impairment of Assets should not be issued as a final

standard, for it is fatally flawed. The information produced by following E55, if issued
in final form, would be unreliable and irrelevant and therefore misleading to
investors.

The major flaw in E55 is that it requires that “value in use” be used to determine
whether the carrying amount of an asset is impaired. To determine value in use of
an asset, management of the reporting enterprise makes its own, private estimate of
the future cash flows that the asset may produce—as contrasted with what unrelated
third parties, i.e. market participants, would estimate as the future cash flows from
that asset. Amounts in financial statements should—in order to be reliable—be
based on information that is free from preparer bias. Thus fair value of the asset, not
value in use, should be used to determine whether the carrying amount of the asset
is impaired, with fair value being the estimated amount of cash the asset would yield
in a sale to an unrelated party, that is, a market participant. Fair value is an amount
that generally can be verified by reference to information outside the enterprise and
thus is reliable. Value in use, being an internal, private estimate, cannot be verified
and thus is not reliable.

Indeed, at the time an asset is acquired by paying cash for the asset, the value in use
of that asset to the buyer may be an amount in excess of fair value, which is the
amount of cash just paid for the asset. Were our accounting system one that allowed
or required periodic revaluation of assets and were value in use a superior number to
fair value in terms of its relevance to the reporting enterprise’s investors, then we
would see revaluations upward at the time assets are acquired whenever value in use
is greater than fair value. I think that investors would not favor that idea.

Value in use of an asset to the holder of an asset is not a relevant amount to
investors in the securities issued by the holder of the asset The cost of an asset to the
holder of the asset is relevant to the holder’s investors at the time an asset is
acquired, for at the time of acquisition the cost of the asset is the best estimate by
market participants of the present value of the cash that may flow from the asset. But,
just as value in use to the holder of an asset is not relevant to the holder’s investors
at the time the asset is acquired, neither is value in use relevant to those investors at
some later date. Insofar as the holder’s investors are concerned, the best estimate of
the present value of cash that may flow from an asset is what marketplace
participants think that amount is, not what the holder of the asset thinks it is.

The holders of assets may do their own internal, private accounting any way they
want to; those holders of assets may decide what is relevant for their own, private
purposes. But the chief concern of the IASC is financial accounting and reporting
for investors and creditors. The information that is produced for investors and
creditors must be relevant to them, and the information must be reliable
(verifiable). Value in use fails on both counts.

In the invitation to comment on E55, on page 5, it is stated that “if no market
exists for the asset, fair value would be estimated in a similar way to value in use as
defined in the Exposure Draft.” Wrong. That procedure requires the use of the
same unreliable (and non-verifiable) information to estimate fair value as would be
used to estimate value in use. An estimate of fair value requires the use of
information external to the reporting enterprise.

For most assets, information regarding fair value of the asset or a similar asset is
available from external sources at a relatively insignificant cost. This is true, for
example, of land, land leaseholds, office buildings, apartment buildings, automotive
equipment, commercial aircraft, earth-moving equipment, on-and offshore oil and
gas drilling rigs, ocean-going vessels, mining equipment, mines, oil and gas reserves,
unexplored oil and gas leases, taxicab licenses, fishing licenses, radio stations, TV
stations, memberships of stock or commodity exchanges, copyrights, and patents.
Even as to unique, one-of-a-kind assets, such as chemical processing plants and
refineries, information from external sources about current input and output prices
can be used by engineers and other knowledgeable people to estimate fair value of
the asset. Only as a last resort, and then only when the cost of getting information
from external sources is judged to be too high in relation to the benefit to investors,
should a final standard allow for the use of internal, private information to estimate
fair value; and, in that case, there should be a requirement for the reporting
enterprise to disclose that the estimate of fair value was based on internal
information as opposed to external information.

I recommend that the final standard on impairment of assets require that fair
value of an asset be compared with the carrying amount of the asset to measure
impairment, and that to the extent possible within cost/benefit constraints that fair
value be estimated by reference to information external to the reporting enterprise,
and that there be required disclosure if the estimate of fair value is made by
reference to information internal to the enterprise.

138 MARK TO MARKET ACCOUNTING

18
Exposure Draft E59: Provisions, Contingent

Liabilities, and Contingent Assets

The Secretary-General
International Accounting Standards Committee

167 Fleet Street
London EC4A 2ES

United Kingdom
9 September 1997

Dear sir,
This letter concerns the IASC’s Exposure Draft E59, Provisions, Contingent

Liabilities, and Contingent Assets.
The requirement in paragraph 14 to recognize a liability when an enterprise has

no realistic alternative but to transfer economic benefits [to another party] is ill-
founded and illogical. That idea could be applied in logic to tomorrow’s salaries and
electricity, resulting in the recognition of a liability today for such items. Maybe the
IASC board would say in response that expenditure for tomorrow’s salaries and
electricity may be avoided by going out of business today and therefore expenditure
for those items is not a liability today; if so, the expenditure for refunds to
customers described in paragraph 17(a) and the expenditure to remove land
contamination described in paragraph 17(b) are also not liabilities today, because
those expenditures may be avoided by going out of business today.

Nor is the expenditure for tomorrow’s “restructuring” a liability today, because
that expenditure may also be avoided by going out of business today, just as
tomorrow’s expenditure for salaries and electricity may be avoided. Maybe the IASC
board would say that expenditure for tomorrow’s salaries and electricity is not a
liability today because no “past event” will have occurred until employees work and
electricity is used. If a past event, an “obligating event,” is critical to the recognition
of a liability, and I think it is, there will be no such event for the refunds to
customers and for removing land contamination described in paragraphs 17(a) and

(b) until the enterprise actually disburses cash; no obligating event for those
disbursements occurs just because the enterprise says it has a liability because of its
“policy,” “published policies,” or “past actions” as stated in paragraphs 17(a) and
(b). (Likewise, there is no obligating event for the additional expenditure for
environmental costs because of the company’s “higher standard” described in
Illustrative Example 3 in Appendix 1.) As well, no obligating event can arise for cash
disbursements in “restructurings” until cash is actually disbursed. In short,
enterprises should not be allowed to recognize liabilities just because they want to or
because they have “policies” or “published policies” or because of their “past
actions” or because they have “higher standards.”

The “no realistic alternative” idea coupled with “constructive obligation” in
paragraphs 16, 17, 18, and 19 will produce liability amounts that managements of
some enterprises will recognize but others will not in circumstances that are similar.
The liability amounts that may be recognized by those who choose to do so will not
be verifiable by outside auditors or anyone else; the amounts simply will be what
managements say the amounts are. We have ample evidence in the USA of
“restructuring” liabilities that were understated or overstated or did not exist at all
because circumstances changed and required either more or less expenditure than
management had thought would be required or because management changed its
mind and abandoned the “restructuring” altogether.

The ideas of “no realistic alternative” and “constructive obligation” look good
outwardly, but they cannot be implemented consistently and comparably by all
preparers of financial statements. The ideas should be scrapped. As I said in my
letter of 12 February 1997 to you, wherein I commented on the Draft Statement of
Principles on Provisions and Contingencies, “liabilities should be recognized as such
in the balance sheet when transfers of economic benefits are required by law, by
contract, or because an enforceable claim exists against the enterprise and the
amounts can be measured reliably.” Liability recognition based on “no realistic
alternative” and “constructive obligation” will produce financial statement amounts
that will be optional on the part of the issuer of the financial statement and that
cannot be made reliable and should therefore be rejected.

Paragraphs 52, 53, and 85 would allow non-disclosure about provisions and
contingencies if such disclosure would be prejudicial to the reporting enterprise in
negotiations with another party. Non-public companies may disclose or not disclose
anything they wish and deal with their security holders and potential security
holders behind closed doors. However, public companies pay a price for being
public and raising capital in the public marketplace and having their securities
traded publicly; part of that price is that their financial reports must be transparent
so that participants in the public marketplace have the necessary information with
which to make informed decisions. Accounting standard setters should not
superimpose their judgment on how much transparency is enough when parties
have opposing interests. Accounting standard setters should require that disclosure

140 MARK TO MARKET ACCOUNTING

which is necessary so that investors may make informed investment decisions. Non-
disclosure should not be permitted in any circumstance.

Yours truly,
Walter P.Schuetze

P.S. I commented on the Draft Statement of Principles on Provisions and
Contingencies; my comments were not accepted by the IASC board in the expo sure
draft. No doubt, some suggestions of other commentators were also not accepted. The
exposure draft would have been a more complete and satisfying document had those
comments and suggestions been summarized in the draft along with the board’s
reasons for not accepting them. I recommend that that be done in the final standard.

ACCOUNTING FOR ASSETS AND LIABILITIES 141

19
Exposure Drafts E60: Intangible Assets, and

E61: Business Combinations

The Secretary-General
International Accounting Standards Committee

167 Fleet Street
London EC4A 2ES

United Kingdom
18 September 1997

Dear sir,
This letter concerns the IASC’s Exposure Drafts E60, Intangible Assets, and E61,

Business Combinations.
E60: Intangible Assets
Internally generated intangibles
This proposed standard, E60, as it relates to internally generated intangible assets,

should not be issued in final form. When to recognize an internally generated
intangible asset, when to capitalize the cost of the recognized asset, and how to
determine that the capitalized cost of an internally generated asset not yet available
for use is not in excess of recoverable amount, are so judgmental, so vague, so
imprecise, and so open to interpretation that the standard, if issued in final form,
will not be a standard except in name. Those enterprises that wish to capitalize
costs, or at least some costs, or some costs in some reporting periods but not in
other reporting periods, will be able to justify their actions. Those that wish to
charge all or most costs to expense will be able to justify their actions. There will be
no comparability whatsoever in the accounting from one enterprise to another for
internally generated intangible assets. Investors will not be well served.

What then should the IASC board do? IAS 9 on R&D apparently is not working
because its application to development costs has the same flaws as this proposed
standard; enterprises may recognize development costs as an expense or as an asset,
depending on very subjective and judgmental criteria. This proposed standard, E60,

will not work. What will work is a requirement to charge to expense when incurred
all costs related to internally generated intangible items and purchased goodwill. Two
rationales support this approach, both of which fit within the IASC’s framework.
One rationale is that costs per se are not assets and should not be recognized as if
they were assets; I have previously corresponded with the IASC in this regard and
will not repeat that correspondence here. The other rationale is that the payback—
future economic benefits-from expenditure (or fair value of securities issued) for
intangible items that are not separable and saleable and for which a fair value
therefore cannot be established is so indeterminate and so speculative that
expenditure (or fair value of securities issued) for such items should not be
represented as an asset. Couple a requirement to charge expenditure for intangible
items (or fair value of securities issued) to expense when made with robust disclosure
about expenditure (or fair value of securities issued) for intangible items, and
investors will be well served and pleased.

Purchased goodwill
I have argued in previous correspondence with the IASC that the cost of

purchased goodwill is not an asset I will not repeat those arguments here. I will,
however, respond to the counter-arguments presented by the IASC board in
paragraphs 34, 35, and 51–3 of Appendix 3 of E60 in favor of recognizing the cost
of goodwill as an asset and not having a separability criterion for the recognition of
an asset.

The IAC board says in paragraph 34(a), in part, “the term ‘resource’ in the
definition of an asset in IASC’s framework should be interpreted broadly. Goodwill
gives an enterprise rights and opportunities to future cash inflows such as the right
to operate in a particular business name, the right to use particular premises, the
opportunity to deal with existing customers of the business, the opportunity to
employ the work-force with its know-how, etc.”

I grant that the right to use a “particular name” may in and of itself be valuable,
particularly if the name stands alone and its sale to another party may be
accomplished without damaging the value of other assets of the enterprise, in which
case the name should be recognized as a separate asset In many cases, however, the
name of the acquired enterprise is not used by the acquiring enterprise, and the old
name disappears; there is obviously no value to the name in that case.

The value of the right to use “particular premises” is captured in the value of land
or land leasehold and is included in the fair value assigned to the identifiable asset
land or land leasehold, so there is no additional goodwill value in particular
premises.

“Existing customers” of the business are not controlled by the business, as those
customers may come and go as they please. The IASC board itself acknowledges in
example B in paragraph 15 of the standard that banks’ deposit customers are not
controlled and therefore the so-called “core deposit” does not meet the definition of
an intangible asset. (In example C of paragraph 15, the IASC board also says that
customer loyalty does not meet the definition of an intangible asset.) It is

MARK TO MARKET ACCOUNTING 143

completely illogical to say that because deposit customers, no matter how loyal, are
not controlled (control being a key part of the definition of an asset) the so-called
core deposit intangible, if generated internally, may not be recognized as an asset
but then to say in the next breath that the core deposit intangible must be
recognized as an intangible asset called goodwill if the core deposit intangible is
acquired through a purchase business combination.

The “existing workforce” as well is not controlled by the acquiree, and therefore
the IASC board itself would not permit an asset to be recognized by the acquiree for
developing that workforce (see example C in paragraph 15 of the standard). But if
an existing workforce is acquired, then the IASC board says that the workforce is
controlled and the asset must be recognized in the name of goodwill. Not logical.

In paragraph 34(b), the IASC board says “(b) the cost of goodwill is incurred
willingly only because the access to future cash flows from the mix of the various
rights and opportunities mentioned above [paragraph 34(a)] is effectively controlled
by the acquirer. Control over goodwill, that is the power to obtain the future
economic benefits from goodwill, can be exercised to ensure that the benefits from
the mix of rights and opportunities acquired are received by the acquirer.” I really
do not know what to make of those words. It strikes me that the IASC board is
saying something like “I breathe, therefore I control the air that I breathe.”

In paragraph 35, the IASC board says “Some argue that whether or not goodwill
meets the definition of an asset is not so important if the recognition of goodwill as
an asset is a pragmatic and acceptable solution that settles a debate that went on at
IASC for many years in the recent past.” What this statement acknowledges is that
indeed there has been and is contention within the IASC as to whether the cost of
goodwill should be recognized as an asset, which calls into question why the IASC
board says in paragraph 29 of Appendix 3 that it does not currently intend to
reconsider the requirement for the recognition of goodwill as an asset. What this
statement also says is that the IASC board (or some delegations to the board) will
ignore its own definition of an asset in its own framework when the definition
produces a result that is undesirable. How then are the IASC’s constituents to view
the definitions of an asset and a liability in the IASC’s framework? Should
constituents continue to look to the definitions for guidance? If the IASC will be
guided by the definitions only when the result is deemed acceptable by the number
of votes that it will attract a political solution, then should not IASC explicitly
rescind its framework and go back to developing solutions to accounting problems
on an ad hoc basis and so inform its constituents?

In paragraphs 34(c) and 51–3, the IASC board says that “separability” is not a
criterion for asset recognition, because it is not a criterion set out in the framework
(the framework is meaningful when the board wants it to be?) and no separability
criterion exists or is even mentioned in IAS 16 on property, plant, and equipment. If
separability is not a criterion for asset recognition, why is the board requiring in
paragraphs 18 and 20 of the standard that future economic benefits must be
specifically attributable to an asset in order for its recognition as an asset? I cannot

144 ACCOUNTING FOR ASSETS AND LIABILITIES

think of an asset that will produce economic benefits specifically attributable to it
and yet not be separable from the enterprise as a whole and transferable to another
party for cash or other economic benefit. I would also point out that the framework
is silent about separability; the criterion is not required to be met for asset
recognition; nor does the framework say that things which are not separable may
qualify for recognition as assets. The Board’s reference to the framework is a non
sequitur.

Saying that separability is not a criterion for recognition of property, plant, and
equipment as an asset and therefore should not be a requirement for recognition of
intangible assets, including goodwill, is a false argument. By their very nature,
individual items of PP&E are separable. No one would even conceive of some item
of PP&E not being separable, although some items would perhaps be separable only
together as a unit. For example, a coal mine in the mountains needs a railroad to get
the coal to market, so the coal mine and the railroad go together as an economic
unit, but the economic unit—the thing that produces cash flows—is separable and
transferable to another party for cash. That is impossible to do for goodwill unless
one considers that the entire business to which the goodwill relates is considered
separable. One could of course consider the entire business as the economic unit, but
in that case the balance sheet would show the investment in the business as the asset
not the individual assets and liabilities of the business. If the reporting enterprise is
an investment company, then of course the asset of that enterprise is its investments
in common stocks and its income is dividends plus or minus changes in value of its
investment; but if the reporting enterprise is an operating company, then its assets
are the individual operating assets that produce cash flows, and goodwill obviously
is not one of those assets, for it produces no cash flow. And, obviously, the proposed
standard is directed toward operating companies, not investment companies.

Finally, regarding separability, I do not understand the example of a license to
operate a radio station set out in paragraph 53. The implication is that the license to
operate the radio station and the transmitting equipment are not separable; I think
that is not the case, at least in the USA. Radio licenses are transferable, with or
without the transmitting equipment.

To sum up, the IASC board’s arguments for recognizing the cost of goodwill as
an asset are not strong.

E61: Business Combinations
Negative goodwill
In paragraph 51 of E61, the IASC board says, in part, “To the extent that negative

goodwill relates to expectations of future losses and expenses that are identified in the
acquirer’s plan for the acquisition and can be measured reliably, but which do not
represent identifiable liabilities at the date of acquisition… that portion of negative
goodwill should be recognized in income when the future losses and expenses
occur.”

The quoted words are an open invitation for issuers to manipulate their income
after an acquisition. The words say that the amounts of future losses or expenses must

MARK TO MARKET ACCOUNTING 145

be reliably measurable. But the amounts of future losses and expenses, because of
their very nature, cannot be made reliable and will not be verifiable by outside
auditors or anyone else. Issuers will say that such and such are the amounts of losses
and expenses that are expected, and outside auditors will not be able to challenge
those amounts. Then, in future quarters, half-years, and years, issuers will be able to
release those amounts into income at will, and again outside auditors will not be
able to challenge the amounts released. Investors will be misled.

The words quoted above from paragraph 51, and the words in paragraph 51(a),
are an admission by the IASC board that negative goodwill does not meet the
IASC’s definition of a liability in its framework, yet the amount of negative
goodwill will be displayed in the balance sheet as a liability. Why does the IASC
board not follow its definition of a liability in its own framework? Should the
IASC’s constituents continue to look to the IASC’s framework for guidance? The
IASC’s constituents will not know what is going on.

This proposed standard, E61, should not be issued in final form.

Yours truly,
Walter P.Schuetze

146 ACCOUNTING FOR ASSETS AND LIABILITIES

20
Business combinations and intangible assets

Director of Research and Technical Activities
File No. 201-A

Financial Accounting Standards Board
401 Merritt 7; P.O. Box 5116

Norwalk, CT 06856–5116
15 June 2000

Dear sir,
Business Combinations and Intangible Assets
This letter is a late response to the FASB’s September 1999 exposure draft on

accounting for business combinations and intangible assets.
At a meeting that I attended last month with Mr Jenkins and Mr Lucas, Chair

and Director of Research, respectively, of the FASB, there was a discussion about
the FASB’s exposure draft and the accounting for the cost of purchased goodwill. In
an exchange with Mr Jenkins, I said, in jest, that it would be OK for the cost of
purchased goodwill to be recognized as an asset by an acquirer of another company
or business “for a moment” before the cost is written off by the acquiring company.
I retract that statement.

I think that the cost of purchased goodwill can never be an asset, not even for a
moment. After subtracting from the purchase price of a company or a business the
fair value of the acquired identifiable net assets (assets minus liabilities), the
remaining amount of the purchase price is called cost of purchased goodwill. It is
the amount left over. In a word, a glob. A glob of cost. It is a cost, only a cost, and
nothing more. The glob should be charged to expense at the date of acquisition of
the company or business.

The glob does not and cannot meet the FASB’s own definition of an asset in
Concepts Statement 6, paragraph 25: “Assets are probable future economic benefits
obtained or controlled by a particular entity.” A cost cannot be controlled. I paid

$22,000 for my Buick automobile. I control my Buick. I can let it sit in my garage.
I can sell it. I can use it to drive to work. I can lend it or lease it to someone else to
use as a taxicab or drive to work. I can pledge it as collateral for a bank loan. I can
give it to my grandson. Or the church. But there is no interpretation of the word
“control” that says I control the $22,000. What I control is the Buick.

The FASB’s definition of an asset requires that there be future economic benefit
controlled by the reporting entity. As to the glob of cost of purchased goodwill, the
board says, in paragraph 184 of the exposure draft, that it “concluded that control is
provided by means of the acquiring enterprise’s ability to direct the policies and
management of the acquired enterprise.” That is faulty thinking. The purchase price
of a company or a business, to the extent it exceeds the fair value of the acquired
identifiable net assets (which fair values can be verified by reference to the
marketplace), represents the buyer’s judgment about the present value of the future
cash inflows of that company or business in excess of the fair value of the acquired
identifiable net assets. Those future cash inflows can come from only one source:
sales of goods and services to customers. Whether and in what amount or degree
those customers will, in the future, buy goods and services from the reporting
enterprise will be determined by those customers, not by the reporting enterprise.
The reporting enterprise obviously does not control its customers’ purchasing
decisions. Thus the control element of the FASB’s own definition is not met as to
the glob.

It is instructive to look at what the FASB itself said about “control” in paragraph
184 of Concepts Statement 6:

an asset of an entity is the future economic benefit that the entity can control
and thus can, within limits set by the nature of the benefit or the entity’s right
to it, use as it pleases. The entity having an asset is the one that can exchange
it, use it to produce goods or services, exact a price for others’ use of it, use it
to settle liabilities, hold it, or perhaps distribute it to owners.

The glob cannot be exchanged for anything; nobody would give a farthing for it; no
creditor would accept the glob in settlement of a debt; no banker would accept the
glob as collateral for a loan; the glob cannot be held the way things generally are
held, for example, the way one holds inventory or land or bonds; the glob cannot be
loaned or leased to anyone; the glob cannot be used to make anything that might be
sold to others; the glob cannot be given to the Red Cross; and, finally, the glob
cannot be distributed to shareholders. Thus the glob of cost of purchased goodwill
does not meet a single one of the features of “control” of an asset that the FASB
itself has described. Why won’t the FASB eat its own cooking?

Following the FASB’s approach to accounting for the glob, balance sheets of
acquiring enterprises will look like dirigibles, filled with the hot air of the glob of
cost of purchased goodwill. Investors will be misled into thinking that the glob has
value as a real and separate asset when nothing could be further from the truth. The

148 MARK TO MARKET ACCOUNTING

board would have recoverability of the amount of the glob be assessed pursuant to
the procedures set out in FASB Statement 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed of Auditors will be unable
to determine whether the glob of cost of purchased goodwill is recoverable under
Statement 121. Recoverability of the glob of cost of purchased goodwill cannot be
verified by an auditor by reference to any competent, evidential matter whatsoever
(an audit requirement). Management of the reporting enterprise can put numbers
on a piece of paper or a computer monitor about its estimate of future earnings of
the business or net assets acquired, but those numbers, which cannot be refuted or
verified by the auditor, are not competent, evidential matter on which an auditor
can base an opinion. (If the auditor is allowed to rely on management’s assertion
about the value of that which is called an asset instead of having to find competent,
evidential matter from sources outside the reporting company regarding that value,
then an audit has no worth. Scrap audits. Just accept the opinion of corporate
management about the value of the reporting company’s assets. Save the cost of
audits.) Nor can recoverability of the glob of cost of purchased goodwill be assessed
by an auditor by reference to a quoted market price or a price in a real market
transaction. The glob does not exist in the marketplace and does not trade.

Incidentally, assessing whether the glob of cost of purchased goodwill is recoverable
(or impaired) by reference to management’s projection, no matter how distant (as far
as the eye can see), of future undiscounted cash flows, as the board proposes and as
set forth in FASB Statement 121, is a very bad idea. In practice today, under Statement
121, there are many examples where the glob was not written down or off until the
soul had departed the body. That is so because management-determined
undiscounted future cash flows almost always will be in excess of the amount of the
glob, thus making the glob “recoverable” unless management itself decides
otherwise. That practice will continue if the exposure draft becomes final.

When, ultimately, reporting enterprises have to write off the glob because of
business downturns, because too much was paid in an acquisition, or for many
other possible reasons, everyone will be damaged. The reporting enterprise will lose
credibility in the marketplace. Auditors will be said to have been negligent or worse
in the conduct of their audits; cries of “Where were the auditors?” will be heard. But
it will be investors, investors who relied on the number in the balance sheet for the
glob as a fit and proper asset, who will take the hit. The FASB should not let that
happen. The FASB is supposed to be the investor’s guardian.

I recommend that the FASB withdraw the exposure draft. Issuing the document
in final form will be a huge mistake. If the FASB goes forward with the accounting
for the glob as proposed in the exposure draft, the FASB will be inundated by a
tsunami of rejection. Rejection by executive and line managers of corporations,
boards of directors and audit committees of corporations, analysts, investors,
creditors, underwriters, journalists, editors, and ultimately Congress.

There are, at bottom, two fundamental, confounding problems in today’s
accounting that are embedded in the exposure draft. Those two problems are that

ACCOUNTING FOR ASSETS AND LIABILITIES 149

(1) the FASB’s definition of an asset does not require that the thing called an asset,
whatever it is, be exchangeable, that is, convertible into cash, and (2) in practice,
with some exceptions for financial instruments and derivatives, writing up assets to
fair value is not permitted. The first of these allows the presentation and
representation of all kinds of junk as assets. Examples of such junk are the costs
of direct-response advertising, the cost of bounties paid by Internet service providers
to original equipment manufacturers for referrals of Internet subscribers (sometimes
“paid” in stock not cash), and the costs of future advertising or other services
purchased by one dot.com from another dot.com (often “paid” in stock not cash).
In none of these cases is the junk something or anything that the reporting
enterprise controls. The junk is spent money—money that is gone. Whether those
expenditures of cash (or issuance of stock) will produce future net cash inflows is a
matter that the company’s customers will decide if and when they buy the reporting
enterprise’s goods and services; those customers’ purchasing decisions obviously are
not controlled by the reporting enterprise. The reporting enterprise cannot sell the
junk, pay off a bank debt with it, pledge it to a bank, lend it or lease it to someone else,
give it to the Red Cross, or pay a dividend with it. In short, it is junk that only an
FASB accountant would call an asset. The FASB now proposes to anoint the glob of
cost of purchased goodwill as another junk asset, perhaps the premier junk asset, but
return of and return on investment with respect to all of that junk depends on the
company’s customers—customers whose purchasing decisions obviously are not
controlled by the company that reports the junk as an asset. No control equals no
asset. All of that junk would disappear from corporate balance sheets if the FASB
required that things must be convertible into cash in order to be presented and
represented as assets in corporate balance sheets, Something that ordinary folks such
as CEOs, line operating managers, boards of directors and audit committees,
analysts, investors, creditors, underwriters, journalists, editors, and US
representatives and senators would understand.

The second problem is that in practice real assets, exchangeable things such as
inventory, land, buildings, copyrights, and patents, are not written up to fair value
except in the case of a business combination accounted for as a purchase. So what
happens is that when one company acquires another, one company’s real assets, for
example, inventory, land, buildings, copyrights, and patents, are written up to fair
value, but those of the other company are not. If Exxon buys Mobil, then Mobil’s
oil and gas reserves are written up to current fair value but not Exxon’s. If Glaxo
buys Wellcome, then Wellcome’s patents are written up to fair value but not
Glaxo’s. The result is a balance sheet potpourri with some asset amounts being old,
ancient, irrelevant amounts and others being current, relevant fair values all jumbled
together, thereby obscuring the relevant new fair values. The prohibition in practice
of writing up assets to fair value is, in large part, the responsibility of the Securities
and Exchange Commission. In the early days of the commission, and more recent
days as well, the staff of the commission has balked at writing up assets to fair value,
saying that the numbers are too soft. Well, nowadays assets are being valued every

150 MARK TO MARKET ACCOUNTING

day. Those valuations are being used in negotiating deals, in Internet auctions, and
in accounting for bulk acquisitions of assets. The Commission’s staff needs to step
over the threshold of the new millennium and remove its objection to writing up
assets to fair value.

Pooling-of-interest accounting was invented in part in response to the problem of
not being able to write up assets to current fair value. Thus, for example, Exxon’s
and Mobil’s and Glaxo’s and Wellcome’s old historical costs of assets could be
added together using pooling accounting and the balance sheet asset amounts would
have at least comparability if not relevance. If, instead, all assets were adjusted
periodically to fair value, then when Exxon and Mobil or two dot.coms combine,
two sets of real assets—both at fair value—would simply be added together. The FASB
could call the accounting for such a business combination a “fair value pooling of
interests,” thus retaining the concept of pooling and simultaneously eliminating the
glob of cost of purchased goodwill and attendant income statement amortization of
the glob, and thereby make CEOs, line operating managers, boards of directors and
audit committees, analysts, investors, creditors, underwriters, journalists, editors,
and everyone else happy. The FASB could then celebrate victory in the war over
accounting for business combinations and the glob.

I think that assets to be shown in corporate balance sheets should be defined as (1)
cash, (2) claims to cash, for example an account or loan receivable, (3) that which
can be sold for cash, for example, land, inventory, equipment, buildings, stocks,
patents, copyrights, oil and gas reserves, salmon farms in Scotland, shoe factories in
Brazil, semiconductor factories in Taiwan, seats on the New York Stock Exchange,
and hack licenses issued by New York city, and (4) derivative contracts having a
positive value to the holder, which value can be converted into cash by entering into
an equal and offsetting contract. I think that all assets presented in corporate
balance sheets should be stated at fair value, which is the amount of cash that the
asset would fetch in an immediate sale for cash even if that sale were under duress. If
the FASB defined assets as I suggest, and required them to be valued as I suggest,
the controversy over pooling-of-interests accounting and accounting for the glob
would disappear.

The question arises: should accounting abandon historical costs in favor of current
fair values of assets? Answer: yes. Accounting must come into the new millennium.
Current fair values of assets are obviously relevant to investors, creditors, and
underwriters. Old, historical costs of assets are obviously not relevant to investors,
creditors, and underwriters. Accountants should do things that help investors,
creditors, and underwriters to make decisions. Getting fair values of assets will not be
as easy as looking in the Wall Street Journal or The Financial Times and finding the
price of many assets. It will take more work and money. But if that were done, the
balance sheet would be relevant instead of what it is today—a dimly lit basement
parking garage for a collection of antique costs. The balance sheet would become a
living document—a relevant document.

ACCOUNTING FOR ASSETS AND LIABILITIES 151

A final question arises: how about just staying with the status quo as some have
urged? Answer: no. The combination of using historical costs of assets and mergers
and acquisitions of businesses causes so much friction that it is clear that the FASB
must do something to fix the problem. I think that the FASB should define assets as
I suggest and prescribe that all assets be presented at fair value in corporate balance
sheets. There is no other solution to the problem of accounting for business
combinations and the glob.

Under the status quo, the accounting for a business combination as a pooling of
interests is subject to such a welter of ambiguous and uncertain rules that corporate
issuers must, as a practical matter, pre-clear their accounting for business
combinations as poolings with the staff of the Securities and Exchange Commission
or potentially face restatements of financial statements. This situation subjects
corporate issuers to the idiosyncratic judgment of the incumbent chief accountant to
the commission or the incumbent chief accountant of the commission’s Division of
Corporation Finance. Accounting standards should be clear. Corporate issuers and
accountants in New York, Hong Kong, London, Paris, Tokyo, and elsewhere
should be able to account for business combinations without having to consult the
commission’s staff.

Moreover, many business combination transactions that would qualify for
pooling-of-interest accounting can be engineered so as to achieve purchase
accounting along with the resultant write-up of assets and recognition as an asset of
the glob.

Thus, in many cases, pooling accounting is optional as a practical matter, which
is not good public policy. We should not have either/or accounting. Still further,
the pooling rules say that bona fide business transactions, such as treasury stock
acquisitions, can preclude pooling accounting; accounting rules should not stand in
the way of business transactions. And, under the status quo, the commission’s staff
often disagrees with the amounts allocated to in-process research and development
and intangible assets other than the glob. The staff also often disagrees with the lives
assigned by corporate issuers to the glob (and certain other intangible assets) for
amortization of those asset amounts and often requires restatement of the financial
statements. The upshot is that many corporate issuers and their auditors are not sure
that their accounting for a business combination as a pooling and their accounting
for the cost of intangible assets and the glob, and subsequent amortization, will pass
muster at the Securities and Exchange Commission without an advance “no
objection” from the staff. That’s no way to run a railroad.

RECOMMENDATION: WITHDRAW THE EXPOSURE DRAFT AND
START OVER.

Yours truly,
Walter P.Schuetze

P.S. According to the FASB’s Action Alert 00–21, dated 7 June 2000, the board is
considering whether to allow the glob to sit on balance sheets without income

152 MARK TO MARKET ACCOUNTING

statement amortization thereof so long as its value is sustained by continuing
investment in the acquired business; the glob would be considered impaired when
the rate of profitability is permanently below that necessary to sustain the original
acquisition value.

The assumptions and judgments made by management of a corporate issuer to
make those determinations will be highly subjective. No auditor will be able to
refute or verify the assumptions and judgments made by management and the
resulting numbers. Great big globs—unauditable globs—will sit on balance sheets.
Investors will be misled into thinking that those globs are fit and proper assets.

ACCOUNTING FOR ASSETS AND LIABILITIES 153

21
Accounting for the impairment or disposal of
long-lived assets and for obligations associated

with disposal activities

Director of Research and Technical Activities
File Reference 210-D

Financial Accounting Standards Board
P.O. Box 5116

Norwalk, CT 06586–5116
7 November 2000

Dear sir,
This letter concerns the board’s proposed statement of financial accounting

standards entitled Accounting for the Impairment or Disposal of Long-Lived Assets and
for Obligations Associated with Disposal Activities.

Asset to be held and used
As to an asset to be held and used, the proposed statement would require that an

impairment loss not be recognized so long as [estimated] undiscounted cash flows
from the use and eventual disposal of the asset exceed the carrying amount of the
asset even though the selling price of the asset is less than the carrying amount
(paragraph 11). Those (estimated) undiscounted cash flows would be the entity’s
own estimates, not those of market participants (paragraph 120). The proposed
statement provides that the asset be tested for impairment when events and changes
in circumstances indicate that the carrying amount may not be recoverable and
gives six examples that indicate that carrying amount may not be recoverable
(paragraph 13) (this proposed standard is substantially the same as the standard
currently embodied in FASB Statement 121). The upshot is that impairment losses
will be recognized if and when, and only if and when, management decides to
recognize those losses. Outside auditors will be unable to challenge a failure by
management to recognize impairment losses on a timely basis just as under FASB
Statement 121 because they will be unable to demonstrate that management’s
estimates are wrong and thus require recognition of impairment losses. When I was

on staff at the Securities and Exchange Commission, I saw this happen many times
under FASB Statement 121, and it no doubt will continue to happen using the
standard in the proposed statement. In fact, under FASB Statement 121,
impairment losses often are not recognized until assets are disposed of, although the
fact of loss is known long before disposal. The standard in the proposed statement is
no standard at all. The board should not go forward with the proposed statement.
Moreover, the board should rescind FASB Statement 121.

I think that the reported amount of every non-cash asset, to be relevant, ought to
be the estimated selling price of the asset minus the estimated cost of selling it. In
my scheme of things, the reported amounts of assets would be written up and down
based on market prices. I can understand a standard that says reported amounts of
assets ought never to be written up above original cost and always ought to be
written down to market price, although I don’t agree with that idea, because it
results in financial statements containing irrelevant and potentially misleading
information when market price is above cost no matter that the reported amount is
described as being cost and no matter how fulsome that description is. But what I
can’t understand and what can’t be explained to investors is a non-standard—one
that says that reported asset amounts may be determined by management of the
enterprise and not by economic events or conditions.

The board says that its answer is practical not conceptual (paragraph 115). But
what the board does not acknowledge and cannot rationalize or defend is the
practical result—the result that I saw when I was on staff at the Securities and
Exchange Commission. That is, impairment losses are recognized when the
management of the reporting entity wants to recognize the losses, including when
assets are disposed of, which is also a management choice, not when the value of the
asset actually declines below cost. Timing of impairment loss recognition based on
management discretion instead of when the economic event of a decline in value
occurs results in financial statements that are not credible.

If the board is unwilling at this time to require that all non-cash assets be marked
to market, up or down, then the board ought at least to require that impairment
losses be recognized whenever the carrying amount is greater than market price.

The board has proposed with respect to certain intangible assets that an
impairment loss be recognized when the carrying amount of the intangible asset
exceeds its observed market price (see paragraph 50 of the board’s proposed
Statement of Financial Accounting Standards entitled Business Combinations and
Intangible Assets, dated 7 September 1999). It is incongruous, grotesquely
incongruous, for the board to require the recognition of an impairment loss for an
intangible asset when the carrying amount is in excess of its observed market price
but at the same time to require that no impairment loss be recognized for a tangible
asset when management-projected undiscounted cash flows exceed the carrying
amount of the asset, even though an observable market price for the asset is less than
its carrying amount. (Tangible assets have observable market prices just as intangible
assets have observable market prices.) Consider the following example. Company X

ACCOUNTING FOR ASSETS AND LIABILITIES 155

owns a medallion issued by New York city, which medallion allows Company X to
operate a taxicab in New York city. Company X’s carrying amount (cost) of the
medallion is $250,000. The market price of the medallion falls to $240,000 because
of an increase in the price of fuel, which cannot be offset by an increase in taxi fares
until New York city approves an increase, which may take a year or longer.
Company X’s carrying amount (cost) of the taxicab (a Ford automobile) is $20,000.
The market price of the taxicab is $18,000. The projected undiscounted cash flows
from operating the taxicab are in excess of $20,000, say $30,000. Company X
would be precluded from recognizing an impairment loss of $2,000 with respect to
the taxicab but would be required to recognize an impairment loss of $10,000 with
respect to the medallion. That answer does not make sense.

Impairment losses for both tangible and intangible assets ought to be recognized
when the carrying amount of the asset exceeds market price.

Obligations associated with disposal activities
The board’s definition of a liability in Concepts Statement 6 requires that there

be a “present obligation” in order for there to be a recognizable liability. But the
three “conditions” set out in paragraph 49 of the proposed statement apparently
allow for the recognition of a liability before there is a “present obligation” to pay cash
(or transfer some other asset) to an obligee. This is evident (1) in paragraph 54,
where the board would allow for the recognition of a liability by an employer to
employees for termination benefits before their termination, although the
employees must work until they are terminated in order to receive the termination
benefits and (2) in paragraph 56, where the board would allow for the recognition
of a liability by a lessee to a lessor for lease termination costs before the lease is
terminated by the lessee. Until the employees are terminated or the lease is
terminated, there is no “present obligation” for the reporting entity to pay cash (or
transfer some other asset); until the employees are terminated or the lease is
terminated, the obligation to pay cash (or transfer some other asset) is optional and
at the discretion of the reporting entity. The board’s own definition of a liability
requires that there be a “present obligation” in order for there to be a recognizable
liability The board should respect its own definition.

Liabilities ought not be recognizable by reporting entities when their
managements say so, which is what the three “conditions” in paragraph 49
apparently amount to. We have seen enough downright awful earnings
management under Consensuses 94–3 and 95–3 issued by the FASB’s Emerging
Issues Task Force, in which liabilities may be recognized when managements of
reporting entities want to and then reversed when those managements want to. The
FASB itself should not issue a standard that will allow this shoddy, reprehensible
practice to continue.

Yours truly,
Walter P.Schuetze

156 MARK TO MARKET ACCOUNTING

22
Business combinations and intangible assets

Accounting for goodwill

Director of Research and Technical Activities
File Reference No. 201-R

Financial Accounting Standards Board
401 Merritt 7; P.O. Box 5116

Norwalk, CT 06586–5116
16 March 2001

Dear sir,
This letter is in response to the FASB’s 14 February 2001 limited revision of

exposure draft issued 7 September 1999, entitled Business Combinations and
Intangible Assets—Accounting for Goodwill.

Cost of goodwill is not an asset
The board continues to assert that the cost of goodwill is an asset. The board

notes in paragraph 46, with apparent approval, that respondents to the 7 September
1999 exposure draft said “goodwill is an asset because it is paid for and future
benefits are expected to arise from it in conjunction with the future benefits from
other assets.” Just because something was “paid for” does not make it an asset. I remind
the board that in its own words in paragraph 179 in its own Concepts Statement 6
“costs incurred are not themselves assets.”

As for the second statement by respondents in support of the cost of goodwill as
an asset, namely that “future benefits are expected to arise from it in conjunction
with the future benefits from other assets”: that description is the description of a
contingent gain. Contingent gains are not recognized as assets until realized. We
don’t count tomorrow’s profits as assets today even if we paid for them. Those
profits have yet to be earned. Indeed, we see many situations—the acquisition of a
money manager is a prime example—where there are no “other assets” to speak of,
where the only thing “paid for” is future profits. But that’s precisely, exactly what the
glob of cost called goodwill represents—expected, hoped-for future profits. Future

profits aren’t assets until they are earned and are in hand in the form of cash or
something that can be converted into cash.

A critical feature of that which is reported as an asset is that it must be controlled
by the enterprise that reports it as an asset. Future profits obviously are not
controlled by the reporting enterprise. Whether future profits ever materialize
depends on whether customers buy the reporting enterprise’s goods and services and
then, crucially, whether the selling price yields a profit. As I have argued in prior
correspondence with the board (see my letter of 15 June 2000), the glob of cost
called goodwill does not qualify as an asset.

If the FASB goes forward with this exposure draft, auditing the recoverability or
“impairment” of the glob of cost called goodwill will be extremely difficult. Many of
the “examples of events or circumstances that would require goodwill of a reporting
unit to be tested for impairment” set out in paragraph 18 of the exposure draft are
so subjective that the external auditor will often have no traction to require a client
to test the glob of cost called goodwill for impairment. Add to that (1) the fact that
the board will allow for organic goodwill (internally generated goodwill), previously
unrecognized as an asset, to be recognized by silent and undisclosed stealth merger
with purchased goodwill (see paragraphs 69 and 70), thereby effectively recognizing
organic goodwill of some immeasurable amount as an addition to the cost of
purchased goodwill; and (2) through a “reorganization” of reporting units (see
paragraph 14), a strong reporting unit, having recognized or previously
unrecognized goodwill, may be reorganized with a weak reporting unit having
recognized but impaired cost of purchased goodwill, thereby propping up the
impaired glob of cost of goodwill. What will happen is that unauditable individual
globs of cost called goodwill will turn into an unauditable amorphous sludge of
goodwill that will be written down because of “impairment” when and only when
management of the reporting enterprise decides that the time is right for a write-
down. That’s no way to run a railroad. Investors will be misled.

Maybe my difference of opinion with the board about what the glob of cost
called goodwill is represents a different view of what kind of financial statements
should be presented to investors. There is no doubt, and I agree, that the owner of
an investment in a business controls that investment. If the financial statements are
to show the investment in a business, and the results of holding that investment,
then the balance sheet will show a one-line item representing the investment, and the
income statement or statement of changes will show dividends flowing from that
investment and changes in the fair value of that investment. That is the way an
investment, and the results of holding an investment, are shown in the financial
statements of an investment company or holding company.

However, today’s financial statement presentations are those of operating
companies, not investment companies or holding companies. In the financial
statements of an operating company, the investment itself is not portrayed. Instead,
the individual operating assets of the business, such as marketable securities, loans,
inventory, land, plant, equipment, mines, patents, and copyrights are portrayed.

158 ACCOUNTING FOR ASSETS AND LIABILITIES

And the results of holding and using those individual operating assets are portrayed
as operating revenue and operating expenses and operating cash flows, for it is those
individual operating assets that generate cash flow; the glob does not and cannot
generate cash flow. It is in the balance sheet of an operating company that the glob
does not satisfy the control criterion even though that criterion is met in the balance
sheet of an investment company or holding company as to the investment itself.

Words and what words represent are crucially important. It is a vast difference to
call an investment in a business an asset as compared with profits that are yet to be
earned. An investment in a business is controlled; it can be sold; it can be pledged as
collateral; it can be given to charity; it can be distributed to shareholders. Not so
with future profits. Profits that are yet to be earned cannot be assets today.

What the FASB could do is require a financial statement presentation as follows:
a balance sheet showing the enterprise’s investments in its various businesses and a
statement of changes showing the cash dividends from those businesses and the
changes in fair value of the enterprise’s investments in those businesses,
accompanied by balance sheets of the various businesses showing the operating
assets (no glob called goodwill) and liabilities of those businesses and statements of
changes for those businesses showing the operating revenues, operating expenses,
and operating cash inflows and outflows of those businesses and changes in fair
values of the operating assets and liabilities. That kind of presentation would have
great transparency—a highly desirable objective—and would be very revealing and
rich in informational content. Investors would be enthralled with such information;
they would wallow in it. I would support such a presentation.

Acquired identifiable intangible assets
Paragraphs 5(a) and (b) set out criteria for the separate recognition of acquired

identifiable intangible assets as follows:

a Control over the future economic benefits of the asset results from contractual
or other legal rights (regardless of whether those rights are transferable or
separable from other rights and obligations).

b The asset is capable of being separated or divided and sold, transferred, licensed,
rented, or exchanged (regardless of whether there is an intent to do so or
whether a market currently exists for that asset).

Paragraph 5 goes on as follows: “An intangible asset that cannot be sold, transferred,
licensed, or exchanged individually meets criterion (b) if it can be sold, transferred,
licensed, rented, or exchanged along with a group of related assets or liabilities. For
example, although a financial institution depositor relationship cannot be
transferred apart from the related deposits, it meets criterion (b) and should be
recognized separately from goodwill.”

Given the words in parentheses, I do not know what paragraph (a) means, and
the basis for conclusions is no help. If an item is not transferable, how can it have
a fair value? The term “fair value” means that something has a cash price. That

MARK TO MARKET ACCOUNTING 159

which is not transferable cannot have a cash price. How can that which does not
have a fair value (cash price) possibly qualify for separate recognition as an asset?
The board needs to explain what that paragraph means. Better yet, delete it.

As to paragraph (b), how can the board possibly conclude that a “financial
institution depositor relationship” meets the requirement of “control” in the board’s
own definition of an asset in Concepts Statement 6? Depositors’ actions cannot be
controlled by the financial institution where depositors keep their money. Demand
depositors can withdraw their money at the drop of a hat without penalty. Time
depositors can withdraw their money at the end of the term of the deposit without
penalty. Even if time depositors withdraw their money before the term expires, the
amount of any penalty is not earned until the depositor surrenders the amount of the
penalty. What the value of a depositor relationship represents is the future profits to
be earned by putting the depositor’s money to work and earning a return over and
above the return promised to the depositor and the costs of handling the depositor’s
money and the cost of insurance of deposits in the case of financial institutions in
the USA. Again, future profits, just like goodwill.

What good does it do for the board to have a definition of an asset in its
conceptual framework if it does not respect and follow that definition in the
standards that the board itself issues? How can board members go around the
country, indeed, the world, trumpeting the merits and usefulness of the board’s
conceptual framework when apparently the definition of an asset in that conceptual
framework is not binding on the board itself. If the board does not like its definition
of an asset, then it should put forth a new definition for review and comment by the
public. I think that investors, the Securities and Exchange Commission, other
federal and state regulators, Congress, and the public at large would welcome and
benefit from a simple definition of an asset along the lines that I have suggested in
published articles of which the board is well aware.

I think the FASB should scrap this project altogether. I think the FASB should go
back to first principles. I recommend that the FASB undertake forthwith a
reexamination of its definition of an asset with a view to including the feature of
exchangeability in the definition, as I have recommended in published articles. In
other words, require that for something to be reported as an asset that that
something must be exchangeable for cash. Were the FASB to change the definition
of an asset to include the feature of exchangeability, standard setting would get a lot
easier. Auditing of financial statements by external auditors would improve
immensely, because the FASB-approved junk in financial statements today can’t be
audited: for example, cost of direct response advertising, deferred tax assets, and now
goodwill, to name just some of the FASB-approved junk that can’t be audited.
Financial reporting would take a quantum stride forward. Investors would be better
off.

Yours truly,
Walter P.Schuetze

160 ACCOUNTING FOR ASSETS AND LIABILITIES

23
The FASB and accounting for goodwill

The FASB published the Statement of Financial Accounting Standards No. 142,
Goodwill and Other Intangible Assets, in June 2001. That document was preceded by
an exposure draft published by the FASB in October 1999 and a second expo sure
draft published by the FASB in February 2001.

The next document, dated 30 April 2001, was submitted by Walter P. Schuetze
to the editor of Barron’s magazine, but the editor did not publish it.

Brace yourself. This piece is about accounting. Be brave.
Since 1950, companies have accounted for stock-for-stock acquisitions of other

companies as poolings. In 1970, the Accounting Principles Board, which was
replaced by the FASB in 1973, issued very detailed, arbitrary rules that have to be
followed in order for pooling accounting to be used in stock-for-stock deals. If those
rules are not met in stock deals or if an acquisition is done with cash or debt,
purchase accounting is required. In purchase accounting, the acquired company’s
tangible assets such as land and equipment and identifiable intangible assets such as
patents and copyrights are revalued upward or downward to market, and any
remaining purchase price is called goodwill, which is reported as an asset and written
down over a period of up to forty years. Now, in 2001, the FASB proposes to do away
with poolings. It also proposes that goodwill no longer be written down each
reporting period but remain on the balance sheet and be assessed periodically for
“impairment.” If impaired, then goodwill would be written down or written off by
way of a charge to operating earnings.

In my opinion, the FASB is repeating the mistake that the Accounting Principles
Board made in 1970 when it concluded that goodwill is an asset.

Is goodwill an asset? Before answering, we need to ask what an asset is. The FASB
defines assets in paragraph 25 of its Concepts Statement 6 as “probable future
economic benefits obtained or controlled by a particular entity as a result of past
transactions or events.” Paragraph 25 is then followed by six paragraphs containing
612 words explaining what the words in paragraph 25 mean. There are 330,000

CPAs who are members of the American Institute of Certified Public Accountants;
329,000 of them don’t understand the FASB’s definition of an asset Only FASB
accountants know what it means, but they can’t explain it in plain English that my
sister, who runs a successful business, can understand. Using FASB jargon, a thing
that my sister, other business people, and 329,000 CPAs call a truck is not an asset;
the asset is the present value of the cash flows that can be earned by using the truck
to haul lumber or bread, viz the “probable future economic benefit.” Thus
abstractions instead of real things are assets.

I say that assets ought to be defined as real things, not abstractions. Call a truck a
truck, not an abstract probable future economic benefit. I define assets by reference
to CASH—something my sister understands. I define assets as (1) CASH, (2)
claims to CASH, for example accounts and notes receivable, and (3) things that can
be sold for CASH, for example trucks, land, oil and gas reserves, marketable
securities, and patents. DO YOU UNDERSTAND MY DEFINITION?

What is goodwill? Take an example. DEF pays 100 cash for XYZ. XYZ has real
assets worth 65; 35 then is goodwill. What is the 35? The 35 is the amount of cash
that DEF paid for hoped-for profits that it may earn from future sales of goods and
services. The FASB says the 35 is an asset because DEF “paid for it.” Since when are
hoped-for future profits assets today, even if we paid for them? Never. Dozens of
cash outlays are made every day with the expectation and hope of future profit:
advertising, R&D, operating new stores or branches at a loss, training new
employees, retraining existing employees, and restructuring businesses are just a few
of the things that are done and paid for today with the expectation and hope of
profit tomorrow. But we don’t call those cash outlays assets. The cash is gone; no
one would call that spent cash an asset. But that’s what the FASB says to do with
the 35—call it an asset. I say “nuts.” Try to sell the 35. Try to borrow money using
the 35 as collateral. Try to pay bills with the 35. Try to give the 35 to the Red
Cross. Try to pay a dividend with the 35. It won’t work.

The FASB also says the 35 is an asset because “future benefits are expected from
it [goodwill] in conjunction with the future benefit expected from other assets.” I
would point out that the market value of the “other assets,” the 65, already reflects
the full earning power of those assets. Moreover, those quoted words sound like
hoped-for future profits to me.

If the 35 isn’t an asset, what is it? The owners of DEF did not receive the 100
paid to XYZ’s shareholders, so we can’t call the 35 a dividend and deduct it from
DEF’s shareholders’ equity (retained earnings) the way we do with dividends to
DEF’s shareholders. If the 35 isn’t an asset and isn’t a dividend, the only
explanation that is left, and one that my sister understands, is EXPENSE. Calling
the 35 an expense doesn’t mean that DEF’s management was dumb and made a bad
deal. The 35 is just like advertising. Just like R&D. Just like training employees.
Just like restructuring a business. Maybe the 35 is a “probable future economic
benefit” to the FASB, but my sister and I don’t think it’s an asset. We’ll call it an
asset when cash, or something that we can convert into cash, is in hand, which
won’t happen until DEF sells goods and services at a profit

162 ACCOUNTING FOR ASSETS AND LIABILITIES

To be sure, charging the 35 to expense at the time of acquisition makes a hole in
earnings. Maybe a deep hole. Maybe turns earnings into a loss. But that hole or loss
can be explained just the way advertising, R&D, and dozens of other cash outlays
are explained. Investors understand those explanations. What investors don’t
understand and what causes immense distrust and ill will, not to mention
shareholder litigation and SEC investigations that take years to resolve and leave
everyone scarred, is when cash outlays for things like R&D and advertising are
capitalized and reported as assets and then later are written off to expense when
hoped-for profits don’t materialize. The same goes for goodwill.

Where are regulators and lenders in this debate? State insurance regulators do not
allow goodwill to be counted as an “admitted asset”; policyholders and beneficiaries
can’t be paid with goodwill. State and federal banking regulators do not allow
goodwill to be counted as an asset in call reports; depositors can’t be paid with
goodwill. The SEC does not allow a broker/dealer to count goodwill as an asset in
determining net capital; customers and other creditors can’t be paid with goodwill.
Commercial bankers and other lenders routinely delete goodwill from borrowers’
balance sheets. Those regulatory and lending practices have stood the test of time.
Regulators and bankers know the difference between a truck and an abstract
probable future economic benefit.

Maybe by now you agree with me that goodwill is not an asset and should be
charged to expense in cash deals, but now you say let’s keep poolings for true
uniting of shareholder interests in stock-for-stock deals. That idea is a busted straight.
First, the idea of “uniting of shareholder interests” is a fairy tale. (Kirk Kerkorian
and Daimler Benz did not stay united.) Second, we accountants, and SEC staff,
have tried to police pooling accounting since 1950, when the first accounting
standard on poolings was issued, but business people and deal makers keep turning
stock-for-stock deals into cash-for-stock deals in dozens of different ways; selling
shareholders want cash. (Long-time readers of Barron’s have been educated by
Professor Briloff about dirty poolings.) Third, the detailed rules or prohibitions that
we accountants and SEC staff use to try to make poolings look like true uniting of
shareholder interests are arbitrary and don’t have a business purpose and indeed
interfere with and thwart legitimate business activity. Why, for example, should
merged companies using pooling accounting be prohibited from buying back stock
or selling significant assets for two years, which are two of those detailed prohibitions?
(If any of these prohibited actions takes place, we accountants and SEC staff say
that action contradicts the idea of uniting of shareholder interests and the pooling
accounting gets undone, retrospectively, and purchase accounting is substituted,
retrospectively, all with great Sturm und Drang because previously issued financial
statements, on which investors relied in making investment decisions, have to be
recalled and restated.) Fourth, the newly constituted International Accounting
Standards Board in London, the FASB, the SEC, and SEC counterparts in various
countries are trying to harmonize accounting around the world, and no one outside
the USA has any fondness for poolings. So poolings have to go.

MARK TO MARKET ACCOUNTING 163

What to do? Well, the FASB and American business need to suck up their gut,
charge goodwill to expense at the date of acquisition, and get on with tending to
business and earning some CASH.

164 ACCOUNTING FOR ASSETS AND LIABILITIES

24
Accounting for financial instruments with
characteristics of liabilities, equity, or both

Director of Research and Technical Activities
File reference No. 213-B
File reference No. 213-C

Financial Accounting Standards Board
401 Merritt 7; P.O. Box 5116

Norwalk, CT 06856–5116
1 May 2001

Dear sir,
This letter concerns the board’s exposure draft of a proposed standard dated 27

October 2000 entitled Accounting for Financial Instruments with Characteristics of
Liabilities, Equity, or Both (No. 213-B) and the board’s exposure draft of a proposal
to revise the definition of liabilities dated 27 October 2000 entitled “An
amendment of FASB Concepts Statement No. 6” (No. 213-C).

File reference No. 213-C
I disagree with the board’s proposal to expand the definition of liabilities to

include “obligations” that require or permit the issuance of the enterprise’s own
equity shares in certain situations that do not establish an ownership relationship, as
for example in the case where shares must be issued to satisfy an “obligation” stated
at a fixed monetary amount. If, for example, a contract requires that the enterprise
issue shares having a market value of $100,000 at the date the shares are issued, the
amount of $100,000 would be reported as a liability.

It should go without saying that a corporation’s own shares cannot be an asset of
the corporation. Otherwise, a corporation’s assets would be limitless and infinite. By
saying that certain “obligations” that may or must be settled in shares are liabilities,
the board implies that a corporation’s shares, which will be used to settle the
“obligation,” are assets of the corporation. That is an incorrect implication that
should be avoided.

If a corporation’s owners, either by corporate charter or through other explicit or
implicit approval, allow managers of the corporation to use the corporation’s shares
as currency, that act does not give rise to an expense. The issuance of shares dilutes
the ownership of current owners of the corporation but does not give rise to an
expense. Decreases in assets, or expenses, arise through the using up of assets or a
decline in the market prices of assets, not through the issuance of shares. It seems
that this proposed expansion of the definition of liabilities is an attempt by the
board to force the recognition of expenses in cases where shares are issued. Just as
the board tried to force the recognition of compensation cost and expense in the
1993 exposure draft related to employee stock options, the board here again is
trying to force expense recognition just because a corporation issues shares.

The board has a misguided, incorrect view of what assets are and therefore what
expenses are. In its Statement 123, Accounting for Stock-based Compensation,
paragraphs 8 and 10, the board seems to say that assets arise because shares are
issued. In its exposure draft dated 14 February 2001 entitled Business Combinations
and Intangible Assets—Accounting for Goodwill, the board says in paragraph 46 that
an asset called “goodwill” arises because it was “paid for.” Not so. Assets—real assets,
not FASB-created assets such as goodwill, direct-response advertising costs, and
deferred taxes—exist separate and apart from whether anyone “paid for” them either
by disbursement of cash, assumption of a liability, or issuance of stock or an option.
Real assets—things like cash, securities, land, buildings, oil and gas reserves, patents,
copyrights, equipment—exist in the real world. Real assets have a market price. The
using up of real assets or a decline in their market prices causes expenses. The
issuance of stock (or an option) does not create real assets; nor does the issuance of
stock (or an option) cause an expense.

File reference No. 213-B
I also disagree with the board’s proposal to require that proceeds received on the

issuance of a compound instrument be allocated to the various parts. For example,
on the issuance of a convertible bond, the board would require that the proceeds be
allocated to the debt feature and the option feature. That’s “as-if” accounting—as if
a corporation had issued two instruments, a debt instrument and an option to buy
shares of the corporation, when in fact only one instrument was issued. Financial
statements should report what happened and what is, not what might have
happened and what might be.

Take the following hypothetical case. Corporation DEF issues convertible debt;
proceeds are 100. DEF allocates 90 to debt and 10 to equity. What is going to
happen when the board requires that liabilities be reported at fair value? Assume
that DEF’s convertible debt trades in the marketplace at 100. Won’t DEF’s liability
be reported at 100? What will happen to the 10? I assume that the 10 will
disappear, as it should. Just as in accounting for hypothetical, as-if “deferred income

166 MARK TO MARKET ACCOUNTING

taxes,” the board is engaging in another time-consuming, money-consuming,
hypothetical, as-if allocation that has no real-world meaning.

Yours truly,
Walter P.Schuetze

167

25
Accounting for stock options issued to

employees

Senator Charles E.Schumer
United States Senate

Washington, DC 20510
25 March 2002

Dear Senator Schumer,
Accounting for stock options issued to employees
At the hearing of the Senate Committee on Banking, Housing, and Urban Affairs

on Tuesday, 26 February 2002, in response to your question, I said that, for
technical accounting reasons, I would not charge expense for stock options issued to
employees. I said that I would explain why.

First, I will define a term. The word “expense” means (1) a decline in the value of
an owned asset, as for example when an account receivable, which was thought to be
collectible, goes bad; or (2) the using up of an owned asset, as for example, using
cash to pay for advertising. (Technically, an expense arises when an obligation to
transfer assets (to use up assets) arises, for example on the receipt of goods or
services where payment of cash in satisfaction of the obligation is delayed in
accordance with normal business terms.)

The Financial Accounting Standards Board, in one of its Concepts Statements,
defines assets as “probable future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events.” (That definition is
followed by six paragraphs of more than 600 words explaining the definition.) The
International Accounting Standards Board’s definition of assets is similar to the
FASB’s in that it is based on “economic benefits.” Under that definition of assets,
the receipt of services from employees is an economic benefit, and the using up of
that economic benefit is an expense. (For FASB mavens, see paragraphs 25–31 of
Statement of Financial Accounting Concepts No. 6, Elements of Financial

Statements, especially paragraph 31, and paragraph 88 of Statement of Financial
Accounting Standards No. 123, Accounting for Stock-based Campensation.) The
value of that economic benefit is hard if not impossible to measure directly, so it is
measured indirectly by reference to the cash paid to the employee by the employer,
state and federal taxes paid by the employer on account of the employee-employer
relationship, and the cost of medical insurance, maternity leave, child care, vacation,
sick leave, and other benefits furnished to the employee by the employer.

Defining assets as probable future economic benefits, as the FASB does, results in
an expense on the receipt and use of services from employees in exchange for stock
or stock options. The value of the economic benefit received is measured indirectly
by reference to the fair value of the stock or stock options issued to the employees.
If, as is generally the case, the stock is restricted stock or if restricted options are
issued, the measurement of the fair value of the stock or the options is generally done
by formula, because reference cannot be made to a market price of the stock or
option.

So if you like the FASB’s definition of assets, that is, economic benefits, you get
an expense when stock or stock options are issued to employees as the FASB
recommended in its Statement 123 issued in 1995, unless you think that it results in
“double counting,” which I will explain later on.

I do not like the FASB’s and the IASB’s definition of assets; “economic benefits”
is too ambiguous, amorphous, and indeterminate. It is not workable. Only FASB
and IASB accountants know what the term “economic benefits” means, but they
cannot explain the term in words that ordinary folk and investors and creditors
understand. When I was on staff at the Securities and Exchange Commission as
chief accountant and as chief accountant of the commission’s Division of
Enforcement, I found “economic benefits” to be so pliable that almost any
expenditure, cost, or debit can be said to qualify as an asset, or at least so it is
asserted by registrants and their auditors, lawyers, and expert witnesses when
challenged by the commission’s staff or the commission itself, either informally or in
court. (For proof, I can show you the court filings by respondents and their very
distinguished expert witnesses.) Moreover, using that definition of assets allows junk,
rusty junk, to get onto corporate balance sheets— junk that cannot be sold to
anyone and therefore has no market value whatsoever—for example, goodwill,
deferred income taxes, income tax benefits of operating loss carry forwards,
development costs, direct-response advertising costs, debt issue costs, and capitalized
interest cost said to relate to the acquisition of fixed assets. The FASB and the IASB
say that that junk has probable future economic benefits. I say nonsense. That junk
does not and cannot earn a penny When it comes time to pay bills or make
contributions to employees’ pension plans, that junk is worthless. Showing that
junk as assets on corporate balance sheets misleads investors. Showing that junk as
assets allows stock prices to soar when the corporate balance sheet is bloated with hot
air.

ACCOUNTING FOR ASSETS AND LIABILITIES 169

In my accounting model, which I have recommended to the FASB and the IASB,
I define assets as follows: CASH, claims to CASH (for example, accounts and notes
receivable), and things that can be sold for CASH (for example, securities, inventory,
trucks; buildings, oil and gas reserves, and patents). Ordinary folk and investors and
creditors understand my definition of assets. Nothing ambiguous about it. There are
no rusty junk assets on balance sheets prepared using my definition of assets. And
when assets, as I define assets (and liabilities, as I define liabilities), are shown on
corporate balance sheets at their market prices as I have recommended to the FASB
and the IASB, the balance sheet presents the corporation’s true economic financial
condition, not a financial position that is determined by reference to the FASB’s
mountain of rules and formulas for computing or determining asset and liability
amounts, the result of which is not understandable by investors, creditors, and other
users of financial statements.

In my accounting, I do not get an expense for the issuance of stock options (or
stock for that matter) to employees in return for their services. No asset, as I define
assets, is used up and no asset, as I define assets, declines in value as the result of the
issuance of a stock option—thus no expense. I will use a simplified example to explain
why no corporate expense arises on the issuance of a stock option to employees or
on the vesting or exercise of the option. For simplicity, I use stock instead of stock
options, but the result is exactly the same as if I had used options.

Year 1. Assume that on day 1 of year 1, all 100 US senators form the Senate
Investment Club (hereinafter “SIC”), and each senator contributes $100 cash,
making a total of $10,000, in exchange for 100 shares of SIC, making a total of 10,
000 shares. During the 250 business days of year 1, each senator takes her/his turn at
the wheel managing SIC for 2.5 days, making investment decisions, collecting cash
dividends and interest, and reinvesting the cash. At the end of year 1, the
combination of cash dividends and interest and increases in the market value of
SIC’s stocks and bonds brings total assets to $10,900.

Assume that a professional investment manager would charge 1 percent of
average assets to manage a mutual fund such as SIC. Question: should SIC have a
charge to expense of $105 (10,000+10,900=20,900×0.5=10,450×0.01 =105),
representing the value of the services contributed by the 100 senators during the
year managing SIC as measured by what an investment manager would have
charged, along with a corresponding contribution to capital of $105? The answer is
“No.” There was no asset, as I define assets, having a value of $105 that SIC owned
during year 1 that was used up. There was no asset, as I define assets, that SIC
owned during year 1 that declined in value by $105. Thus no expense.

Year 2. Assume that on day 1 of year 2, the 100 senators decide to hire Warren
Buffett to manage SIC for year 2 and to pay him, at the end of year 2, cash equal to
1 percent of average assets during year 2. Assume that at the end of Year 2, SIC’s
assets have increased in value from $10,900 to $11,700, before a reduction for the 1
percent of average assets (or $ 113) paid to Mr Buffett. Question: is the $113 paid

170 MARK TO MARKET ACCOUNTING

to Mr Buffett an expense in year 2? Answer: Yes. An asset—namely cash of $113—
was used up. The using up of an asset is an expense.

Year 3. Assume that on day 1 of year 3, Mr Buffett and the senators agree that at
the end of year 3, in return for Mr Buffett’s managing SIC for year 3, each of the
senators will convey to Mr Buffett one share of the stock of SIC instead of paying
him cash equal to 1 percent of the average assets of SIC during year 3, (Or, as an
alternative, SIC will issue 100 shares of SIC stock to Mr Buffett.) Come the end of
year 3, SIC’s assets stand at $15,000, and each senator conveys to Mr Buffett one share
of stock of SIC. Thus Mr Buffett receives SIC stock worth $150 from all of the
senators at the end of year 3. Had Mr Buffett and SIC continued with the 1 percent
of average assets arrangement as in year 2, SIC would have paid Mr Buffett cash of
$133 (11,700•113= 11,587+15,000=26,587×0.5=13,294×0.01=133).

Question: In Year 3, should SIC have an expense of $150, $133, or zero? If there
is an expense of either $150 or $133, there is a contribution to capital of like
amount. The answer is zero. No asset, as I define assets, of SIC having a value of
either $150 or $133 was used up during Year 3. No asset, as I define assets, that SIC
owned during Year 3 declined in value by either $150 or $133. Thus no expense.

Showing an expense, as would be done using the FASB’s and the IASB’s
definition of assets, in either year 1 or year 3 is, in my opinion, as-if or pro-forma
accounting. As if something was done that was not done. As if cash had been paid
out. I think that accounting should be based on the facts of what was and what is,
not what might have been if something that was not done had been done.

What happened in year 3 was that 100 senators had their ownership in SIC
reduced by 1 percent by each conveying one share of stock of SIC to Mr Buffett. (If
SIC had issued 100 shares of SIC stock to Mr Buffett, exactly the same result would
have obtained.) After year 3, there are 101 owners of SIC. Each of the senators—in
her/his personal income statement for year 3—has an expense of 1 percent of $150,
or $1.50, but SIC has no expense. The expense of the owners of SIC is not imputed
to SIC. SIC accounts for its assets and expenses, not its owners’ assets and expenses.
Some say that the corporation has a cost when stock or options are issued to employees
in return for services and that cost must be accounted for. What cost? There is no
cost to the corporation. The cost is that of the owners of the corporation, as shown
in the reduction of their percentage ownership of the corporation.

Remember the definition of an expense: the using up of an asset or the decline in
value of an asset. Imputing reductions in 100 owners’ (the senators) interests in SIC
to SIC as an expense in year 3 implies that SIC’s stock is an asset of SIC. That is
fundamentally wrong. The stock of an entity is never an asset of that entity. Were
the stock of an entity an asset of the entity, the entity’s assets would be infinite and
unlimited. The stock of an entity is an asset of the owners of the entity. How
owners of an entity use their ownership interests, or what happens to the value of
their ownership interests, does not affect the corporation’s assets or the value of
those assets. The corporation does not account for its owners’ assets or changes in its
owners’ assets.

ACCOUNTING FOR ASSETS AND LIABILITIES 171

The rearrangement of the ownership interests in SIC in year 3 is exactly what
happens when a corporation issues options to employees and the employees exercise
the options—there is a rearrangement of the ownership interest of the corporation.
But, importantly, no asset of the corporation is used up and no asset of the
corporation declines in value when an option is issued or when an option vests or is
exercised. Indeed, when an option is exercised, cash equal to the exercise price
comes into the corporation.

Importantly, the issuance of a stock option to an employee does not change the
market capitalization of the corporation as measured by the market value of the
outstanding shares and the value of the outstanding option; any decline in the
market value of outstanding shares shifts to the option. Thus no expense. If there
had been a true expense—the using up of an owned asset or the decline in the value
of an owned asset—then the market value of the outstanding shares and option
should have declined. For example, if the market value of the stocks and bonds
owned by SIC declined by 1 percent, that decline would be an expense of SIC. And
that decline would be reflected —dollar for dollar—in the value of the SIC shares
held by the senators. But, if the 100 senators convey 1 percent of their shares to Mr
Buffet, or if SIC issues 100 shares to Mr Buffett, there is no decline in the value of
SIC’s assets—thus no expense. And, finally, on the exercise of an option by an
employee, the market value of the corporation’s outstanding shares should increase
by at least the amount of cash that is received by the corporation on the exercise of
the option—again, no expense.

** The effect of the expense deduction will be more pronounced in situations where the
number of stock options (and therefore the value of the stock options) exceeds 1 percent of
outstanding shares as in the SIC example.

Now take a look at the issue of double counting. Although net income in my
accounting model is not reduced for an expense equal to the value of stock or stock
options issued to employees, the number of shares in the earnings per share
computation is the same in my model as in the FASB’s model. Thus the dilutive
effect of the issuance of options or shares is reflected in the earnings per share.
Reducing net income by way of an expense charge for the value of stock or stock
options issued to employees—as per FASB methodology—inappropriately counts
the effect twice; that is, the corporation’s shareholders see net income (the
numerator in the earnings per share computation) reduced and the number of

172 MARK TO MARKET ACCOUNTING

shares (the denominator in the earnings per share computation) increased—thus
double counting. I will illustrate using year 3 above.

Then, if there were a requirement to impute the value of stock options granted to
employees to the corporation as an expense, as in year 3 of SIC above, a further
question would arise: what should be done in those cases, as in year 1 of SIC above,
where employee/owners of corporations are paid no cash compensation, or nominal
cash compensation, and there is no expense, or nominal expense, in today’s income
statements for their services? For example, Mr Buffett of Berkshire Hathaway and Mr
Gates of Microsoft are paid nominal cash salaries by those corporations. Should
there be a pro-forma charge to expense in the income statements of those
corporations for the true value of Mr Buffett’s and Mr Gates’ services, that is, the
“economic benefit,” along with a contribution to capital of like amount? My answer
is that no amount beyond the cash salaries paid should be charged to expense. If an
amount in addition to the cash paid should be charged to expense, that amount
would have to be measured directly by reference to the value of the services of Mr
Buffett and Mr Gates. What would that amount be—$25 million? $50 million?
$100 million? A yet greater amount? Who would make that measurement? I
assume, but do not know, that the FASB and the IASB would require an expense. I
do not know how the FASB or the IASB would measure the value of those services
and thus the expense.

If it would be appropriate to require a charge to expense in the case of an owner/
employee being paid little or no cash salary, as in the case of Mr Buffett and Mr
Gates, what would be done in the obverse case—where owner/ employees are being
paid more in cash salaries, bonuses, and the like than they are worth? To be
consistent, would there be a requirement to measure directly the true value of their
services, that is, the “economic benefit,” and charge any excess to capital as a
preferential dividend, thereby reducing the expense charge that is measured by cash
salary, bonus, and the like? Not the way I would do the accounting, but perhaps yes
in the FASB’s and the IASB’s accounting.

My example above—an investment club—is simplified for the purpose of
illustration. But exactly the same concepts would apply to a manufacturing
company, a service/entertainment company, a high-tech company, or any other
company.

I hope this letter is helpful. I will be pleased to elaborate or explain further.

Yours truly,
Walter P.Schuetze

cc: other members of the Committee on Banking, Housing, and Urban Affairs

ACCOUNTING FOR ASSETS AND LIABILITIES 173

26
Proposed interpretation: guarantor’s

accounting and disclosure requirements for
guarantees, including indirect guarantees of

indebtedness of others

TO: Director of Major Projects and Technical Activities
File Reference No. 1124–001

Financial Accounting Standards Board

FROM: Walter P.Schuetze
8940 Fair Oaks Parkway

Boerne, TX 78015

SUBJECT: Proposed interpretation: guarantor’s accounting and disclosure
requirements for guarantees, including indirect guarantees of indebtedness of others

DATE: 14 July 2002
The board proposes, in paragraph 8 of the proposed interpretation, that

guarantors initially measure and report guarantee liabilities at fair value. But then
the board declines, in paragraph A17, without explanation and without giving its
rationale, to give guidance on how the guarantee liability should be measured and
reported subsequently. Guarantee liabilities should always be measured and reported
at fair value, and the board should say so. If the board leaves the matter open, as in
the proposed interpretation, practice will likely be mixed, which obviously is not in
the best interest of financial reporting. That’s no way to run a railroad.

The proposed interpretation is brimming with exclusions, with the result that
many guarantees will not be covered by the final interpretation. A guarantee is a
guarantee, and the board should include all guarantees within the final
interpretation. Otherwise, financial reporting will be further diversified, needlessly.
The board itself should not be a contributor to diversity in financial reporting.
Again, no way to run a railroad.

27
Your proposed interpretation

Consolidation of certain special-purpose entities

TO: Director of Major Projects and Technical Activities
Financial Accounting Standards Board

File Reference No. 1082–200

FROM: Walter P.Schuetze
8940 Fair Oaks Parkway

Boerne, TX 78015
Tel: 210–698–0968

Email: schuetzewalterp@aol.com

SUBJECT: Your proposed interpretation: consolidation of certain special-purpose
entities

DATE: 6 September 2002

This proposed interpretation by the board is incredibly complex and arcane. I
have great difficulty figuring out to which entities the interpretation is supposed to
apply, and then how to apply the interpretation. I don’t know whether the word
“entities” is even the right word. Half a dozen examples, written in plain English,
sure would help.

But, assuming that I have correctly figured out what the board is saying, then I
can’t believe what the board is proposing. In its determination and rush to get off-
balance-sheet liabilities of SPEs onto someone’s balance sheet after Enron’s
implosion last year and the subsequent publicity about Enron’s off-balance-sheet
activities and the publicity about the board’s inaction for a decade or more about
accounting for SPEs, the board now proposes to contaminate the liability side of
corporate balance sheets by putting onto corporations’ balance sheets “debt” that
the reporting corporations do not owe. In the process, the board now also proposes
to contaminate the asset side of corporate balance sheets by putting onto
corporations’ balance sheets “assets” that the reporting corporations do not own,

cannot sell, cannot pledge as collateral, cannot give to charity, and cannot distribute
to shareholders—assets that belong to SPEs. Not only will that accounting not
improve financial reporting, it will also confuse and potentially mislead investors.

The board says, in paragraph 14, that the assets (of the SPE) initially shall be
reported (measured) by the “primary beneficiary” at fair value. The term “fair value”
means the amount of cash that an asset would produce in a sales transaction. “Fair
value” has no meaning with respect to an asset that the reporting enterprise does not
own and therefore cannot sell; it is a non sequitur. Investors who read corporate
balance sheets are entitled to assume that when an asset is reported at fair value (or at
cost for that matter) that the reporting enterprise owns the asset and can sell it for
cash. No amount of disclosure to the effect that the reporting enterprise really does
not own the asset and therefore cannot sell it will cure the misleading impression
given by reporting the asset in the balance sheet

The board says in the summary of the proposed interpretation that “The
relationship between an SPE and its primary beneficiary results in control by the
primary beneficiary of the future benefits from the assets of the SPE even though
the primary beneficiary may not have the direct ability to make decisions about the
uses of the assets.” What a strange meaning and use of the word “control” that
statement by the board is. How can one control something and yet “not have the
direct ability to make decisions about the uses of” that something? That does not
make sense.

The board says, in paragraph 184 of its own Concepts Statement 6, that “an asset
of an entity is the future economic benefits that the entity can control and thus can,
within limits set by the nature of the benefit or the entity’s right to it, use as it
pleases. The entity having an asset is the one that can exchange it, use it to produce
goods or services, exact a price for others’ use of it, use it to settle liabilities, hold it,
or perhaps distribute it to owners” (underlining added by me). Reporting
enterprises can do none of those things with assets of SPEs. So how can the board
square the words in its own Concepts Statement 6 with the proposed interpretation?
I can’t. Under the board’s proposed interpretation, reporting enterprises that are
“primary beneficiaries” will report phantom assets and liabilities, phantom revenues
and expenses, and phantom cash flows. The board is going to make a yet further
hash of already horribly complex financial reports that are produced by application
of the encyclopedia of Byzantine FASB rules already in place—financial reports that
are not understandable by or comprehensible to investors. That is not just my
opinion; read speeches by the chairman of the Securities and Exchange Commission
wherein he makes the same point. See, for example, Chairman Pitt’s speeches of 22
October, 8 November, and 29 November 2001 on the SEC’s website.

What is it that is the problem with accounting for SPEs? The problem is that
guarantors are not reporting on their balance sheets as liabilities the fair value of
guarantees (or undertakings) that they have issued. When an SPE is created, the
creator thereof often guarantees the value of the assets, or a portion of the assets,

176 ACCOUNTING FOR ASSETS AND LIABILITIES

held by the SPE. Or guarantees that the assets in the SPE will produce a certain
level or amount of cash flow. Or undertakes to perform services related to the SPE
at less than a fair rate for those services. Or the creator of the SPE guarantees the
payment of the interest and principal, or some of the interest and principal, of the
debt of the SPE. The solution to the problem is for the board to require that the
guarantor, on its balance sheet, report as a liability the fair value of its guarantee at
the date of the issuance of that guarantee, with a corresponding charge to earnings.
Then, at each balance sheet date thereafter, the fair value of that guarantee would be
redetermined, with the change, plus or minus, entered into earnings. Along with
disclosure of the pertinent facts about the guarantee or undertaking, this is a simple,
straightforward solution to the problem—a solution that will be understandable by
and comprehensible to investors. And this solution to the problem will not have
corporations reporting phantom assets and liabilities, phantom revenues and
expenses, and phantom cash flows.

As to leases, lessees often guarantee the residual value of the leased asset, which
guarantee becomes operative at the end of the lease. But most leases that I have seen
also impose on the lessee a termination penalty, which penalty generally becomes
operative immediately upon signing the lease. Payment of periodic amounts under
the lease by the lessee (so-called lease payments) generally is optional in that the
lessee need not make the periodic payment but may terminate the lease and pay the
termination penalty. Thus the termination penalty is the amount that the lessee
unconditionally must pay, and that is the amount (undiscounted) that the lessee
should report as its liability under the lease, with a corresponding charge to
earnings, not the amount of the guaranteed residual value or the present value
thereof.

If, as to lessees, the board requires that some measure of the lessee’s commitment
to disburse cash, say the termination penalty amount, be reported as an asset, then
the board will be repeating the mistake that it made in FASB Statement 142, where
it said that the cost of goodwill is an asset. Unless the amount recognized as an asset
for a lease can be realized in cash through a sublease, that amount is just like
goodwill in that it represents hoped-for future profits. Leased assets differ from
owned assets in that owned assets can be converted into cash through a sale. If the
lessee may not sub-let the leased asset, the only way that any amount represented as
an asset for a lease can be realized in cash is through future use of the leased asset.
Thus the realization of that amount depends on customers buying the lessee’s
services or product at a price that yields a profit. Lessees obviously do not control
their customers’ actions; thus to a lessee the asset is a contingent asset—just like
goodwill. Contingent assets are not recognized until realized in cash.

The board should not require, or even permit, primary beneficiaries of SPEs or
lessees to report as assets on their balance sheets things that they do not own, cannot
sell, cannot pledge as collateral, cannot give to charity, and cannot distribute to
shareholders. Investors will be confused and potentially misled by that reporting.

MARK TO MARKET ACCOUNTING 177

Part II

The implications of accounting practices for
auditing

28
Schuetze on the implications of accounting

practices for auditing
Peter W.Wolnizer

This section comprises four articles and two speeches. They cover a variety of
matters, including the role and legal liability of auditors, audit committees, peer
reviews, and internal control.

However, Walter Schuetze makes the following vital, but seldom made,
observation—accounting rules and practices have profound implications for the
function and reliability of auditing and, indeed, for the independence of auditors.
Accounting rules determine whether financial statements are of a kind that can be
audited or verified by recourse to evidence that is external to the reporting enterprise
and hence beyond the control of the managers who prepare financial statements.
Schuetze demonstrates how conventional accounting rules give managers significant
discretion in how they account for assets, liabilities, and income. He shows how
conventional cost-based accounting yields many elements in financial statements
that cannot be verified by auditors by recourse to evidence outside the reporting
enterprise: to commercial evidence in the market-place. He also shows how mark-to-
market accounting would be good for auditors, because it would require the
reporting enterprise to substantiate elements of financial statements by independent
evidence. Schuetze advocates that the names of the persons or entities that provide
the market price information should be disclosed in the financial reports.

These are important ideas, ones that are largely ignored in the auditing literature.
Mark-to-market accounting, auditing by reference to corroborable evidence drawn
from the marketplace, and disclosure of the persons or entities that provide the
evidence would strengthen the independence of auditors in far more significant
ways than the myriad of déjà vu proposals that are currently being advanced.
Without detracting in any way from the proposals that are designed to strengthen
auditor independence, Schuetze argues that until the control of the information
reported in financial statements is taken out of the hands of the management of
reporting enterprises, by an accounting that requires assets to be marked to market

and liabilities valued at settlement prices, audit judgment will never be independent
of management. It is for this reason that he argues that a fundamental problem
underlying contemporary auditing is a technical accounting problem.

By explaining the connection between the rules that govern financial accounting
and reporting and the reliability (and independence) of audit evidence and hence of
the auditing function itself, Walter Schuetze has elevated auditing to the rigorous
safeguard over the quality of financial information that it was intended to be.

The articles

The first article, “Disclosure and the impairment question,” published in the
Journal of Accountancy (1987), deals with the impairment of asset values, how such
impairment should be disclosed and the problems associated with surprise large-
scale write-downs of asset values. “Many believe that either the management or the
independent auditors, or both, should have warned users of financial statements
about the possibility of these write-downs or foreseen the necessity for write-downs
and reported them earlier. Such beliefs erode confidence in financial reporting.”

Lacking definitive guidance in the literature or in the accounting standards,
accounting practices are inconsistent: “There is no uniform practice in selecting the
circumstances that justify or require a write-down, and there is no uniform practice
in measuring the amount of such write-downs.” Reflecting on his experience of
implementing the “probability approach” recommended in FASB Statement 5,
which, as a member of the AICPA’s Accounting Standards Executive Committee,
he endorsed in 1980, Schuetze concludes: “Unless the [FASB] simply requires that
assets be written down to fair value whenever fair value is less than cost, the task of
developing definitive, operational criteria for recognition and measurement of write-
downs will be extremely difficult to complete.”

As an interim solution, while the FASB works on the “recognition and
measurement problems,” Schuetze proposes that “The FASB should require
disclosure of the fair value [estimated price in an immediate, but not forced, sale for
cash] of a non-monetary asset, or reasonable groupings of such assets, whenever the
fair value of the asset at the date of the most recent balance sheet is less than its
cost.”

It is here that Schuetze makes the vital association between the quality of
accounting numbers and their auditability or verifiability: “The rule would be
unambiguous. Whether fair value of an asset is less than its cost is—at least in theory
—a question of fact, not a judgment. …From the independent auditor’s perspective,
this would be a tremendous improvement over the current state of affairs. As it is
today, we do not search for facts. Rather, we rely on management’s assertions about
its judgment about recoverability of cost, and then we apply our judgment to that
judgment.” Schuetze goes on to make the second vital connection—he links
auditability with evidence: valuing assets at their fair value “would mean that the
preparer of the financial statements would have to produce evidential matter about
the fair value of assets to satisfy the auditor.”

180 MARK TO MARKET ACCOUNTING

Because the idea of getting fair value for all non-monetary assets may be costly,
Schuetze, in this paper, suggests an alternative accounting treatment: “a
standardized measure of cash flow to be disclosed in all cases when it is negative,
along with the cost of the asset. The standardized measure of cash flow would be the
net amount of annual operating revenue of the asset, minus the annual related cash
operating costs, both based on the most recent year’s results, minus one year’s
hypothetical interest to carry the cost of the asset with that interest to be measured
using the 30-year US Treasury bond rate at the balance sheet date. This disclosure
would allow users to make their own subjective determinations about the fair value
of the asset and whether a write-down is necessary.” He recommends that this
disclosure requirement be “tested in the field” and argues that it “would alleviate
considerably the surprise that frequently accompanies business failures.”

It is apparent from his later papers, notably “What is an asset?” (1993) and “True
north” (2001), that Schuetze subsequently takes a more rigorous approach to the
determination of fair value—what an asset or collection of assets would fetch if sold
on the balance sheet date—and the extent of asset impairment would be determined
by the difference between fair value at two dates. Only the initial write-down would
be determined relative to cost, since assets would thereafter be valued at fair value.
Asset impairment in mark-to-market accounting is synonymous with depreciation—
a diminution in the market selling price of the asset (or collection of assets).

This is the first paper in which Schuetze makes the vital, but commonly and widely
overlooked, association between accounting rules, independent evidence, and the
function of auditing as independent verification. That is, auditors cannot
authenticate financial statements independently of those who prepare them unless
the accounting numbers are supported by evidence external to the reporting
enterprise: by evidence from the marketplace. In the case of fair value, that means by
recourse to independent evidence of current selling prices for assets and current
settlement prices for liabilities.

That association is the subject of the second article in this section: “The liability
crisis in the USA and its impact on accounting.” First delivered as a speech at a
conference on the “liability crisis” held at Northwestern University on 7 April 1992
soon after he was appointed chief accountant to the SEC, the paper was published
in Accounting Horizons in June 1993. It was written against the backdrop of the
savings and loan (S&L) crisis. It is one of relatively few pieces of literature that
addresses the liability of auditors and audit risk in terms of accounting rules: “For
ten to fifteen years, I have contended that until generally accepted accounting
principles are unambiguously defined, auditors of financial statements cannot see
clearly the target they intend to strike. So long as asset and liability recognition and
measurement standards are fuzzy, auditors of financial statements do not always hit
the ball and indeed sometimes strike out when at bat.”

Referring to the S&L catastrophe, Schuetze argues that “the cost of the savings
and loan bailout and the related litigation are in significant part due to ambiguity in
accounting standards regarding revenue recognition on loans and loss recognition
on loans…and ambiguity, or outright contradiction, in loan loss recognition rules

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 181

postponed too long the recognition of losses on those ADC loans.” He concludes:
“To my mind, the ADC loan case is the perfect case for saying that ambiguous
accounting principles, not auditing failure, are to blame for the litigation and
resultant auditor liability arising out of the S&L catastrophe.”

In the context of ADC loans, he provides numerous examples where current
accounting standards are so ambiguous as to allow management significant
discretion and judgment in determining the accounting for loans. He examines the
substance over form argument and concludes that “If we follow a substance over
form rule, we will have anarchy in financial accounting. Substance over form itself is
so ambiguous that if people are instructed to use that general rule instead of specific
rules or standards, then financial statements will become highly individualized.”

Next, he examines the argument that those who prepare financial statements
should be allowed to exercise their judgment within broad, general financial
accounting and reporting standards. He concludes: “That approach will not work
either. A lot of people applied their judgment to accounting for ADC loans. That
process produced a judgmental mess that is costing untold, uncounted billions.”

Addressing the judgment applied to the identification of impaired loans (the
“probable” criterion in FASB Statement 5), he argues: “We can see in current
practice that the probable criterion has not worked. Identification of impaired loans
under that criterion is all over the map, which produces wide non-comparability in
financial statements.” That same ambiguity extends to the identification and
measurement of the impairment of the cost of marketable securities (when a decline
in value is “other than temporary” where “other than temporary” is undefined in the
accounting standards) and to the cost of long-lived assets. And many other examples
are given.

In confronting the conventional wisdom that ambiguous accounting standards
have little or nothing to do with auditor liability, Schuetze concludes: “I disagree. I
think plaintiffs and their lawyers clearly see that any time an issuer or an issuer’s
auditor is in the dock, that person is vulnerable. That person is vulnerable because he
or she relies on fuzzy notions such as ‘probable’ and ‘cost’ is recoverable through the
ordinary operation of a going concern, ‘realization’ of tax benefits is ‘more likely
than not,’ and market value declines are ‘temporary’ Those terms, and others of
similar ambiguity, are red meat for the plaintiff’s bar.” Returning to a recurrent
theme, he argues that “if financial statement amounts were required in the case of
assets to be not in excess of market values, or fair values, and not less than
settlement amounts in the case of liabilities, these amounts would be relevant to
investors. Investors would more readily understand the financial statements. …
Likewise, it seems to me that, from the standpoint of auditors protecting themselves
from the risks of litigation, they too should welcome simple and unambiguous
accounting standards that produce financial statements that can be easily
understood by reasonable investors and by the courts,”

The third article, “Reporting by independent auditors on internal controls” (The
CPA Journal, October 1993), was adapted from a speech given by Schuetze, as chief
accountant to the SEC, at a symposium in 1993 sponsored by The CPA Journal on

182 MARK TO MARKET ACCOUNTING

the topic “In the Public Interest.” The article is a response to a proposal by the
AICPA and the AICPA’s Public Oversight Board (POB) that the SEC should
require public companies to report publicly on the effectiveness of their internal
controls over financial reporting, and that auditors should be required to express an
opinion on those representations by management. The AICPA and POB argued that
such a requirement would militate against fraudulent financial reporting.

Again, Schuetze questions the conventional wisdom:

I question whether public reporting on internal controls over financial
reporting by registrants and their independent auditors would reduce so-called
fraudulent financial reporting and litigation against external auditors. …No
amount of reporting on internal controls will ferret out any more fraud or
provide any better techniques to find it than the audit of the financial
statements should have done in the first instance. …I question…how
reporting on internal controls by independent auditors is going to deter
fraudulent financial reporting resulting from “cooked books” when
management was not deterred by the requirement for an annual audit and
was able in the first instance to conceal the fraud from the auditors during the
audit.

He then homes in on the critical issue:

Another, and more prevalent, cause of improper financial reporting is the use
of ambiguous accounting principles to overstate assets, equity and income. …
Auditors suggest that they cannot stop this kind of misconduct because,
under existing accounting principles, assets may be recognized even though
there is no way to audit or verify, with reasonable assurance, that any future
benefit exists or that the asset amounts will be recovered or realized. This kind
of improper reporting occurs, therefore, not because of a failure of auditors to
discover crooked schemes, but because of a failure in the way accounting
principles are written. No amount of internal controls reporting can cure this
problem.

He provides several examples from current accounting standards to illustrate the
point, but the critical observation in the paper is that internal control systems, being
designed and implemented by management, will not militate against fraudulent or
misleading financial statements if there is managerial collusion to perpetrate a fraud
or where management has wide discretion in determining the reported financial
values of assets, liabilities, equities, and income.

The fourth article in this section, “A mountain or a molehill?” (Accounting
Horizons March 1994), was also first delivered as a speech—on this occasion, to the
AICPA’s 21st Annual National Conference on Current SEC Developments, 11
January 1994. It was a powerful and influential speech, for it prompted the
AICPA’s Public Oversight Board to appoint an Advisory Panel on Auditor

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 183

Independence, chaired by Donald Kirk, former chairman of the FASB, to examine
Schuetze’s charges. The article concerns auditor independence.

Schuetze acknowledges the importance and propriety of auditors being, and
being seen to be, independent of their clients: “In the last analysis, therefore, it is his
independence which is the certified public accountant’s economic excuse for
existence.” However, he quickly turns “to an issue that has vexed and bewildered me
since I came to the commission two years ago. I refer to situations in which auditors
are not standing up to their clients on financial accounting and reporting issues
when their clients take a position that is, at best, not supported in the accounting
literature or, at worst, is directly contrary to existing accounting pronouncements. To
me, auditors giving way to their clients, subordinating their view to their clients’,
raises a nasty issue about independence in appearance and in fact. In my opinion, an
auditor’s independence…is jeopardized as much by his or her subordinating
judgment about a financial accounting and reporting issue as it is by investing in
securities issued by a client, lending money to a client, or borrowing money from a
client—perhaps even more so. At least insofar as money matters are concerned, if
there were disclosure to the investor about that fact, then the investor would be on
notice and could be guided by the facts, although I would not—definitely not—
advocate such an approach. Not so with subordinated judgment, which is insidious.
There is no way to communicate impaired or colored judgment.”

Referring back to a speech he gave to the 1992 annual meeting of the American
Accounting Association? where he raised, among other things, the issue of auditor
independence (see the section “Accounting for assets and liabilities”), Schuetze
acknowledges that some senior members of the profession “suggested privately that I
was making a mountain out of a molehill.” Not so, says Schuetze. Rather, he
provides several telling examples of “incredible accounting proposals” that have been
put forward, even since 1992, by registrants and their auditors. Those examples
make for fascinating, indeed incredulous, reading. In respect of accounting for stock
options, Schuetze argued that “It also appears to me, and other outside observers,
that CPAs may have become cheerleaders for their clients.” A bold statement,
perhaps, but one for which there was, and remains, compelling evidence.

Having sustained the argument, Schuetze then poses the question: “Could
continuation of such a trend be anything other than an invitation to Congress, the
SEC, and other regulators to regulate more heavily, and directly, the auditing
profession in particular and financial reporting in general? Could continuation of
such a trend lead investors, particularly institutional investors, to find alternative
ways to corroborate issuers’ representations in their financial statements?” These are
thought-provoking questions. In the wake of the most significant unheralded
corporate collapses and retrospective financial restatements in corporate history,
following the demise of Enron, Schuetze’s first question was prophetic, for that is
precisely what has happened in the Sarbanes-Oxley Act of 2002, Will his second
question, likewise, be prophetic?

The strength of the arguments put in this article is enhanced by Schuetze’s
closing statement:

184 MARK TO MARKET ACCOUNTING

As many of you know, these comments do not come from an ivory tower. I
have lived and worked in the accounting profession for more than 30 years. I
know the realities of saying “no” to a client. I know the disappointment some
clients express when the auditor makes a decision to support an accounting
proposal that may reduce those clients’ reported earnings. I know the long
and often heated telephone calls and client visits, the emotional strain, and
the financial cost that follow such decisions. But I also know the rewards—a
clean conscience, not having to worry about losing lawsuits based on the
merits, and pride in the profession and the credibility of financial accounting
and reporting.

As a consequence of this speech and article—and the consequent establishment of
the Kirk Panel—that panel recommended, on page 2 of its report of 13 September
1994, as follows:

(The panel] urges the accounting profession to look to the board of directors
—the shareholders’ representative—as the audit client, not corporate
management. It calls for direct interface between the entire board and the
auditor at least annually, and an expanded interface with the audit
committee.

To increase the value of the audit, the [panel] calls for a new level of
candor from the auditor. Auditors would not only apprise the board of what
is acceptable accounting, they would be expected to express their views, as
accounting experts, on the appropriateness of the accounting principles used
or proposed by the company.

That expansion of the auditor’s responsibilities is a far-reaching, perhaps
revolutionary, proposal, one that is responsive to complaints about “lowest common
denominator” accounting principles often applied with “rose-colored glasses.”

Subsequently, in 2000, the AICPA’s Auditing Standards Board issued Statement
on Auditing Standards No. 90, Audit Committee Communications, which requires the
auditor to “discuss with the audit committee the auditor’s judgment about the
quality, not just the acceptability, of the entity’s accounting principles as applied in
its financial reporting…The discussion should be open and frank.” That
requirement is consistent with the recommendation of the Kirk Panel in 1994.

In “True north” (2001) and the R.J.Chambers Memorial Research Lecture (2001),
Schuetze develops the notion of independence much further, linking it strongly with
the “competence” of the evidence to which auditors have recourse in forming their
opinions. That is, he articulates a complete notion of independence in auditing: the
evidentiary underpinning for the establishment of an independent auditor opinion
as well as the ethical dimensions of the auditor-client relationship.

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 185

The speeches and addresses

There are two unpublished speeches in this section. The first, “Comments on
certain aspects of the special report of the AICPA’s Public Oversight Board of 5
March 1993,” was delivered on 27 May 1993 at the University of Southern
California’s SEC and Financial Reporting Institute. The speech focuses on those
three of the twenty-five recommendations contained in that report that were
addressed to the SEC. The POB believes that the recommendations, if implemented,
would improve the quality and reliability of financial statements and increase the
likelihood of auditors detecting fraud and other illegal acts.

The first of these recommendations—that the SEC should require SEC
registrants to disclose whether their auditors have had a peer review, the date of the
most recent peer review, and its results—is similar to a proposal by the SEC as part
of a comprehensive review of the proxy rules in 1985. Twenty of the thirtyeight
commentators on that proposal, including the American Bar Association, were
opposed to it. Schuetze questions the “benefit investors and potential investors
would get from such a disclosure standing alone.”

The second recommendation concerns audit committees: “The SEC should
require registrants to include in a document containing the annual financial
statements a statement by the audit committee (or by the board if there is no audit
committee) that describes its responsibilities and tells how they were discharged.”
The POB cites the 1987 Report of the National Commission on Fraudulent Financial
Reporting (the Treadway Commission) as support for this recommendation.
Schuetze also questions this recommendation: “The information already required to
be disclosed about audit committees, the commission’s decision not to implement
the Treadway recommendation in 1988, and the anticipated states’ rights issues
involved, will have to be reviewed carefully before the commission makes any
determination on whether to proceed with this recommendation.”

The third recommendation deals with registrants’ disclosure about the
effectiveness of internal control systems related to financial reporting. Schuetze
admits to being “in two minds” about an independent auditor’s reporting on
management’s assessment of its internal controls: “I recognize the argument that the
more managements, audit committees, internal auditors, and external auditors think
about, talk about, and focus on internal controls, the better the internal controls
will be and will become.” On the other hand, “I know…that there are in this world
a certain number of people with dishonest bones in their bodies. All the reporting
on internal controls in the world is not going to stop those people from defrauding
the public and, in the process, the external auditor as well. …In addition, I am told
that there will be a cost, perhaps a significant cost, to registrants, especially the
smaller ones, to get their external auditors to report publicly on their internal controls.
…So I do not know which way to lean.”

The second speech, with the tantalizing title “Enforcement issues: good news, bad
news, Brillo pads, Miracle-Gro, and Roundup,” was delivered to the Twenty-sixth
Annual AICPA National Conference on SEC Developments in Washington on 8

186 MARK TO MARKET ACCOUNTING

December 1998. Speaking as the chief accountant of the Enforcement Division of
the SEC, Schuetze tackles questions pertaining to auditor independence head on.
Referring to his observations “that some issuer registrants are turning not to their
regular auditors but to ‘forensic’ auditors from other firms when questions are raised
about the issuer’s financial statements,” he observes: “The forensic auditors then
take their Brillo pads and scrub the issuer’s balance sheet until it looks like a newly
minted copper penny, and the restatements to assets, liabilities, equity, and income
are the size of an elephant.” He then asks the critical question: “Which firm did the
real audit? Which firm’s partners and staff did not have their objectivity clouded or
enveloped by relationships developed at picnics or golf outings or at sports events
with their clients? Which firm’s partners and staff did not have their skepticism
dulled by the fact that a former partner of the audit engagement partner is now the
client’s CFO? That the audit partner and the CFO are also doubles partners at the
tennis club on Saturday mornings?” Compelling and timely questions, indeed. He
then raises an interesting query: “Should auditors have to follow the same rules with
respect to their public company audit clients that I as an employee of the US federal
government have to follow with respect to regulated entities or persons? Would
there be fewer restatements if there were not such fraternizations?”

Turning to the accounting issues with which the Enforcement Division of the
SEC deals, he states: “The Enforcement Division was formed in the 1970s. …I have
heard every one of the division’s chief accountants give speeches wherein they
described their cases. Well, nothing has changed. Registrants are still doing the same
things.” What things? Cooking the books—by “premature revenue recognition”;
“deferral in the balance sheet of costs that should have been reported in income as
operating expenses”; “assigning inflated, often outrageously inflated, dollar values to
exchanges of non-monetary assets, particularly with related parties”; “not disclosing
the existence of related parties and transactions with related parties”; “recognizing
officers’ salaries as receivables”; “recognizing cash taken from the corporation by
officers as cash in the bank or as a direct reduction of stockholders’ equity instead of
a charge to expense”; “including brass bars that look like gold bars in an inventory
of gold”; “bleeding into income, without disclosure, ‘reserves’ established in
business combinations or in so-called restructurings.” In several recent cases, he
observed, “the bleeding [of reserves into income] turned into a hemorrhage from a
severed carotid artery!”

Examining the use and abuse of reserves, Schuetze states:

I thought that the “reserves” issue had been resolved in 1975, when the FASB
issued its Statement 5 on Accounting for Contingencies, but nowadays general
reserves are like crab grass. They are everywhere. Tax liability cushions.
Deferred tax asset cushions. Inventory reserves. Bad debt reserves. Merger
reserves. Restructuring reserves. They are like dirt. Some companies keep a 55-
gallon drum of Miracle-Gro in the garage, and they irrigate their crab grass
general reserve accounts with a garden hose hooked up to the drum. Then
along comes the Division of Corporation Finance, in its review of filings by

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 187

issuers, and squirts Roundup from a spritzer bottle on issuers’ balance sheets,
but the crab grass general reserves keep re-emerging. And the reserves are
being used to manipulate earnings.

Whither auditing amid this shoddy and defective accounting?

I have now seen several non-audits…Auditors accepting, with little or no
evidential support, values ascribed to both monetary and non-monetary
assets. …Auditors not doing substantive audit work but relying on so-called
analytical procedures where the evidence, or lack thereof, cries out for
substantive audit work. …Auditors not doing cut-off work for sales and
purchases, with the result that sales of the next period are booked in this
period with a corresponding increase in receivables from customers, and
accounts payable for purchases of inventory in this period not booked until
next period with the inventory recognized in the balance sheet resulting in
understated costs of sales and overstated margins.

Here again, Schuetze makes the vital connection: poor accounting spawns poor
auditing. Poor accounting produces financial statements for which there is a lack of
commercial—independently corroborable—evidence. Poor accounting gives great
discretion to the preparers of financial statements in the determination of the
classification and quantification of assets, liabilities, equities, and income. Poor
accounting renders auditors dependent upon the management of the reporting
enterprise for all of those matters. In the end, there is the risk that investors will lose
confidence in the integrity and reliability of auditing as the rigorous process of
quality assurance that is intended by law.

And it is on that sobering note that Schuetze concludes his speech:

Will investors stop drinking from the well called audits by “independent
certified public accountants” and sample the water in other wells? You may
say there are no other comparable wells. Not so. When investors begin to
believe that their interests are not being protected by external auditors, those
investors will find an alternative to protect their interests, in ways other than
an audit by independent certified public accountants.

188 MARK TO MARKET ACCOUNTING

29
Disclosure and the impairment question

Journal of Accountancy, December 1987

In the short run, here’s the way to go: disclosure of the fair value of
long-lived, non-monetary assets.

Walter Schuetze

Accounting for impaired long-lived, non-monetary assets is an old problem, one of
the acknowledged imperfections of financial accounting and reporting. The problem
is when to recognize “impairment”—the inability to recover the carrying amount—
by a write-down and how to measure it. Practice is inconsistent, and rules that
would establish consistency thus far have eluded standard setters. In view of the
confusion, this article proposes an interim solution: required disclosure of the fair
value of non-monetary assets when fair value is less than cost.

Impairment and the winds of change

The first feature of the problem is its urgency. Economic change is now so rapid
that various assets all too frequently lose some or all of their capacity to recover cost.
This is obvious in the case, say, of a dramatic drop in the price of oil, which impairs
the cost, or value, of oil and gas drilling rigs. The conditions that lead to such events
can be treated as unique, but ongoing conditions also lead to asset impairment.
Technological advances that create obsolescent plant, equipment, patents, and
licenses are common events today, and rapid technological progress is a condition
that will continue to be with us. Similarly, intense competition and rapid changes in
market demand are standing rather than temporary conditions, and both can impair
asset values. Still other conditions that can impair asset values, most notably volatile
interest and foreign exchange rates, have been around long enough to make their
disappearance hard to anticipate.

All these factors suggest that users of financial statements would benefit from
information on impaired long-lived assets.

The urgency of the problem is also illustrated by the sense of surprise that is
sometimes expressed when huge write-downs are reported. Many believe that either
the management or the independent auditors, or both, should have warned users of
financial statements about the possibility of these write-downs or foreseen the
necessity for write-downs and reported them earlier. Such beliefs erode confidence
in financial reporting.

Little clarity in the literature

The second feature of the problem is that the authoritative literature contains no
clear, operational guidance on accounting for impaired long-lived assets.

In fact, the absence of a rule on when to write down impaired long-lived assets
was explicitly acknowledged by the Financial Accounting Standards Board in 1977
in Statement No. 19, Financial Accounting and Reporting by Oil and Gas Producing
Companies: “The question of whether to write down the carrying amount of
productive assets to an amount expected to be recoverable for future use of those
assets is unsettled under present generally accepted accounting principles. This is a
pervasive issue that the Board has not addressed.”

Despite the support that one can find in various places in the literature for the
concept of mandatory write-downs of impaired long-lived assets, serious practical
problems have made it difficult to establish a rule for consistent practice:

• How does one know when the cost of an asset is sufficiently impaired to
necessitate a write-down?

• Should the write-down be mandatory if there is a chance that the asset will regain
its stature or only when impairment is permanent?

• How does one distinguish with confidence between temporary and permanent
impairments?

• How does one disaggregate impaired individual assets from other elements in an
operating unit?

• Should write-ups be permissible for assets that have become unimpaired?
• Under what circumstances, if any, would a shortened amortization period or an

accelerated depreciation method coupled with a reduction in residual value be
more appropriate than a write-down (for example, a change from units-of-
production depreciation to an accelerated depreciation method for facilities
operating significantly below normal levels)?

• How should write-downs to recognize impairments be measured?

The measurement alternatives include fair value, replacement cost, undiscounted
future cash flows, and discounted future cash flows using a choice of several possible
interest rates. The measurement base can assume break-even, a normal profit
margin, or less than a normal profit margin. The discount rate can be the

190 MARK TO MARKET ACCOUNTING

enterprise’s incremental borrowing rate, its cost of capital, a risk-free rate, or some
other rate,

Inconsistencies in practice

Current practice is marked by two types of inconsistency. There is no uniform practice
in selecting the circumstances that justify or require a write-down, and there is no
uniform practice in measuring the amount of such write-downs. As of this writing,
the FASB’s Emerging Issues Task Force has discussed the issue three times but has
reached a consensus on only one point: that the dominant practice is to recognize
permanent rather than temporary impairment.

There are some hard data on inconsistencies in practice. The Financial Executives
Institute (FEI) surveyed a number of companies reporting unusual charges in 1985.
Of twenty-four companies reporting write-downs of fixed assets retained by the
business (either idle or still in use), 60 percent of the decisions to write down the
asset were based on a probability test similar to that in FASB Statement No. 5,
Accounting for Contingencies, and 36 percent of the decisions were based on the
permanent decline test. Thirteen of the write-downs (46 percent) were measured by
net realizable value, five (18 percent) by undiscounted expected future cash flows,
four (14 percent) by the net present value of future cash flows, and three (11
percent) by some combination of these methods. The remaining three write-downs
were based on current replacement cost, percentage of historical cost based on
expected long-term capacity, and historical cost reduced by the cost of holding a
building that could not be sold.

These and other data in the FEI survey show inconsistencies in practice, but a
plurality of the participating companies (48 percent) responded in the negative to a
question asking whether additional guidance from the FASB on accounting and
reporting on the impairment of fixed assets was desirable; 38 percent responded that
additional guidance would be useful. What the survey does not point out explicitly
is that, in the absence of a decision to abandon or dispose of assets at a loss, the
timing and amount of any write-down are largely discretionary.

Proposals and projects

In 1980, the AICPA’s Accounting Standards Executive Committee (ASEC)
recommended that the probability approach in FASB Statement No. 5 be used to
determine whether to report the inability to recover fully the carrying amounts of
long-lived assets. Under this approach, declines would be recorded in the accounts if
the inability to recover cost is probable and the amount can be reasonably
estimated. This proposal was an explicit rejection of the concept that declines should
be recognized only if the assets are permanently impaired. The ASEC concluded that
the concept of permanent decline in value was too subjective and restrictive.
However, the ASEC also recommended that no one method of measurement be
prescribed for determining the amount of the write-down.

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 191

Looking back on the ASEC’s conclusions in 1980—which I endorsed at the time
—one can understand the rejection of subjective determinations of permanent
impairment But it is harder, now that our experience with Statement No. 5 has
more than doubled, to agree that its probability test could serve as a replacement
because it is sufficiently less subjective than the permanent impairment test In both
cases, the preparer of the financial statements and the independent auditor must
foretell the future.

The FASB’s staff is now considering whether to recommend that the board add
to its agenda a project on accounting for the inability to recover fully the carrying
amounts of long-lived assets. One immediate issue for the FASB’s staff is to define
the project’s objective. The objective could be to develop guidance on recognition
and measurement of impairment of long-lived assets, or it could be to develop
disclosure requirements that minimize the likelihood that users are taken by surprise
when long-lived assets are written down. Unless the board simply requires that
assets be written down to fair value whenever fair value is less than cost, the task of
developing definitive, operational criteria for recognition and measurement of write-
downs will be extremely difficult to complete. The board will have to answer many
difficult questions, some of which are offered in the following.

Roadblocks to recognition and measurement criteria

In order to develop operational criteria as to when to recognize and how to measure
impairments of long-lived assets, the Financial Accounting Standards Board will
have to answer the following questions, among many others:

1 For an investment type of asset, for example a common stock, how long should
the quoted market price stay below cost before a write-down is required? Six
months? One year? Three years? May a write-down be reversed if the quoted
price later bounces back?

2 For operating-type assets, such as plant, equipment, and patents,

• Should the presence of an operating loss (assuming “operations” is clearly
defined) for some period of time require a write-down? How long? Six
months? One year? Two years? When does an asset become operational?

• Should the management of an enterprise be entitled to assume improved future
cash flows from the asset or from reasonable grouping of assets?

• Should the future cash flows be discounted? At what rate?
• Once write-downs have been made, may those write-downs be reversed if

cash flows improve?
• Should the question of a write-down be considered in tandem with the

amortization/depreciation policy related to the assets? Estimated useful lives?
Residual values?

192 MARK TO MARKET ACCOUNTING

3 How does one deal with the intangible asset that arises from the application of
FASB Statement No. 87, Employers’ Accounting for Pensions, in relation to
pensions?

4 For how long should losses or “subnormal” earnings be allowed to run before
goodwill should be written down?

5 May assets be grouped? (This question is larger than it may seem, involving
more than just write-downs.) What is the unit of accounting—individual assets
or groups of assets?

An interim solution

I suggest an interim solution while the FASB works on the recognition and
measurement problems or before it adds the item to its formal agenda. The FASB
should require disclosure of the fair value (estimated price in an immediate, but not
forced, sale for cash) of a non-monetary asset, or reasonable groupings of such
assets, whenever the fair value of the asset at the date of the most recent balance
sheet is less than its cost.

This proposal has several things going for it:

1 The rule would be unambiguous. Whether fair value of an asset is less than cost
is, at least in theory, a question of fact, not a judgment. I do not deny that the
facts may be hard to come by (and perhaps in some instances costly), but at
least we know how and where to look for facts. And in some instances the facts
are easy to come by, for example price quotations in newspapers for marketable
equity securities. From the independent auditor’s perspective, this would be a
tremendous improvement over the current state of affairs. As it is today, we do
not search for facts. Rather, we rely on management’s assertions about its
judgment about recoverability of cost, and then we apply our judgment to that
judgment.

I also acknowledge that fair value of an asset is often not a clear-cut, indisputable
fact, but at least we would be making judgments about facts, not speculating about
future events and their outcomes, as we do today in trying to decide when and by
how much to write down assets.

2 The disclosure would not be discretionary.
3 If there were no disclosure about cost being in excess of fair value, the user of

the financial statement would be entitled to assure that fair value of the asset
was at least equal to or in excess of cost at the date of the balance sheet (One
day later, however, fair value might be less than cost.)

4 If there were no disclosures and if the auditor’s report was unqualified, the user
of the financial statement would be entitled to assume that the independent
auditor was satisfied that fair value of the asset was at least equal to or in excess
of cost. This would mean that the preparer of the financial statement would

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 193

have to produce evidential matter about the fair value of assets to satisfy the
auditor.

5 Preparers and their independent auditors would not have to speculate, as they
do today in assessing the need for write-downs, about future events and their
outcomes, such as:

• Will the fair value—for example, the quoted market price of a common
stock listed on the New York Stock Exchange—bounce back above cost?
How likely is it to bounce back? How long will it take?
• Will cash flows from operations, but before interest charges, improve for an
asset such as plant? Even if such cash flows do improve, will interest rates
hold steady, decline, or rise?
• How will cash flows from operations be affected by local, regional, national,
and international competition?
•How will cash flows from operations for operating assets be affected by
foreign exchange rate changes?

This proposal probably cannot be applied to goodwill, or most goodwill. Unless
goodwill attaches to specific assets or groupings of assets (for example, to separate
divisions), it cannot be sold and has no separate value. I would exclude goodwill
from the disclosure requirement.

How much would it cost to implement this proposal? I don’t know. Business
people generally know, sometimes only intuitively, the fair value of their assets; they
know what the marketplace would pay for the assets. However, I doubt that
independent auditors will accept intuition and unsupported assertions by
management. The degree of auditor association with the disclosure will have to be
worked out. However, if auditor association appears to be a significant hurdle, it
should be sacrificed, at least at the outset. The disclosures could be labeled
“unaudited” or could be placed outside the basic financial statements and notes.

A practical alternative

Because obtaining objectively determined fair values of non-monetary assets is often
difficult and costly, I suggest an alternative required disclosure that would be more
practical for some assets. The alternative would be a standardized measure of cash
flow to be disclosed in all cases when it is negative, along with the cost of the asset.
The standardized measure of cash flow would be the net amount of annual
operating revenue of the asset, minus the annual related cash operating costs, both
based on the most recent year’s results, minus one year’s hypothetical interest to
carry the cost of the asset, with that interest to be measured by using the 30-year US
Treasury bond rate at the balance sheet date.

This disclosure would allow users to make their own subjective determinations
about fair value of the asset and whether a write-down is necessary.

194 MARK TO MARKET ACCOUNTING

A field test for disclosure

Given the support for mandatory write-downs of impaired long-lived, non-
monetary assets, the serious practical problems already cited must be considered the
major obstacle to achieving a definitive, operational standard that would result in
consistent practice and comparability for recognizing and measuring write-downs.
The FASB may solve these problems, but we cannot assume that the answers will
come quickly. Until the answers are in hand, users of financial statements would
benefit from disclosures. However, the disclosures will not be comparable or
consistent if they entail the same practical problems that have beset recognition and
measurement in the accounts. In other words, the disclosures cannot be based on
predicting future events and their outcomes. For this reason, I suggest consideration
of required disclosures of fair value when it is below cost.

The relationship of costs to benefits for this disclosure may or may not be favorable,
but we need to find out. One way to do this would be to subject the proposal to a
test in the field.

I believe that such disclosure would also alleviate considerably the surprise that
frequently accompanies business failures. A business failure is almost always
preceded by a decline in the fair value of the assets of the enterprise. Disclosure of
those declines should help to serve as a harbinger of failure and thus reduce surprise
and shock, unless the declines are sudden, as in the case of the price of oil in 1986.
Such disclosure should all but eliminate surprise related to write-downs, sometimes
involving huge amounts, in the absence of a business failure.

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 195

30
The liability crisis in the USA and its impact on

accounting

These remarks were presented at a conference on the liability crisis held at
Northwestern University, 7 April 1991, and subsequently published in Accounting
Horizons Vol. 7, No. 2, June 1993, pp. 88–91

For ten to fifteen years, I have contended that until generally accepted accounting
principles are unambiguously defined, auditors of financial statements cannot see
clearly the target they intend to strike. So long as asset and liability recognition and
measurement standards are fuzzy, auditors of financial statements do not always hit
the ball and indeed sometimes strike out when at bat. We need to have clearly
articulated standards that result in financial statement descriptions of assets and
liabilities and amounts for those assets and liabilities that are clearly understood
and, in addition, are relevant.

I think that the cost of the savings and loan bailout and the related litigation are
in significant part due to ambiguity in accounting standards regarding revenue
recognition on loans and loss recognition on loans. Better accounting could not
have prevented the S&L catastrophe; the seeds for that catastrophe were sown when
thrifts were permitted to leave the staid business of long-term residential loans so
they could compete with businesses offering uninsured investments with wider
returns. One significant way thrifts found they could compete was by using insured
funds to lend builders and developers 100 percent of the acquisition price of risky
assets by way of what have come to be known as “acquisition development and
construction,” or “ADC,” loans. But ambiguous revenue recognition accounting
rules allowed revenue recognition on those loans to extend too far and too long.
And ambiguity, or outright contradiction, in loan loss recognition rules postponed
too long the recognition of losses on those ADC loans.

ADC loans became prevalent in the thrift industry in the early 1980s. At that time,
the only pertinent words on or about revenue recognition in the literature, which
did not constitute an accounting rule or even guidance, were contained in old

Accounting Principles Board Statement 4, paragraphs 150 and 151, which said in
part:

Revenue is generally recognized when the earnings process is complete or
virtually complete…Revenue from permitting others to use
enterprise resources, such as interest…is recognized as time passes…at the
amount expected to be received.

The guidance in the then existing AICPA Savings and Loan Audit and Accounting
Guide (page 33) regarding recognition of income on loans was consistent with the
words in APB Statement 4. In fact, the words in the 1979 guide almost assume that
interest income is recognized on loans as per the loan contract and do not suggest
much caution regarding revenue recognition.

Even though the drafters of APB Statement 4 and the 1979 guide had never
heard of or seen an ADC loan when those documents were written, the revenue
recognition words in those documents were applied to ADC loans, and interest
income was recognized on those loans based on the contractual terms; so was fee
income. Fee income and interest income were recognized by the thrift holders of
ADC loans, and the loan balances and accrued interest on those balances kept
growing and growing even though in most cases no cash was ever received by the
thrifts.

During that time, there was the general provision in the literature that loan losses
should be recognized when it was probable that such losses had occurred and could
be estimated, which is from FASB Statement 5. This statement, issued in 1975,
addresses when losses should be recognized, not how those losses are to be measured,
a point to which I will return. Statement 5 was followed closely by Statement 15,
which was issued in 1977. It addresses troubled debt restructurings.

In paragraph 1 of Statement 15, the FASB said that Statement 15 does not
address allowances for estimated uncollectible amounts and does not prescribe or
proscribe particular methods for estimating amounts of uncollectible receivables.
Statement 5 is in place, and presumably Statement 5 governs when there is a loss,
but Statement 5 does not define how to measure any loss. But, after appearing to
defer to Statement 5, Statement 15 then goes on to say that if the holder of a
troubled receivable expects to collect the entire carrying amount of the receivable,
whether through the medium of interest or principal collection, no loss is to be
recognized, no matter how long the collection might take. This means that
economic losses may be retained in balance sheets and called assets so long as there
is some expectation that some day the amount of the loan will be collected. As a
result, we have Statement 5 saying to recognize a loss when it is “probable” that a
loss has occurred, we have Statement 15 saying not to recognize a loss if the carrying
amount of the loan may ultimately be collected, and we have no guidance, in any
event, on how to measure such a loss. Talk about confusion. Talk about contradictory
guidance. Talk about ambiguity. An entire generation of accountants was plunged
into darkness by Statement 15. Those who prepared financial statements did not

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 197

know whether to go forward, backward, sideways. Whether to put their left foot
first or their right foot first. Independent auditors were similarly confused.

The thrift industry was in stress, so it opted to recognize the fee income and
interest income on ADC loans and not to recognize any losses on those loans until
the project assets were foreclosed, even though the fair values of the ADC projects were
known to be less, often far less, than the ADC loan carrying amount and accrued
interest. Independent auditors more or less agreed that the authoritative literature
either required, or at least permitted, that accounting. Regulators, who were trying
to keep an entire industry afloat, turned a blind eye to the accounting. Ultimately,
equity investors were done in, and the American taxpayer is footing the bill through
the bail-out of the deposit insurance system, and accountants are paying millions to
the government and others in legal judgments.

To my mind, the ADC loan case is the perfect case for saying that ambiguous
accounting principles, not auditing failure, are to blame for the litigation and
resultant auditor liability arising out of the S&L catastrophe.

Some may say that if issuers of financial statements and their independent
auditors had put on their thinking caps and looked at the substance of the ADC
rather than their form, then the ADC loan asset would have been accounted for as
an investment in real estate rather than as a loan and all of the fee income and
interest income would not have been recognized and the problem would not have
gotten as serious as it finally did. Well, maybe so, but think about that for a minute.

If accounting for the substance of events, circumstances, arrangements, and
transactions is indeed the overarching guiding rule, then there is no need for
standards. Or a standard-setting body. Presumably, all of us can see, clearly see, the
substance of things, and will account for the substance of them, and everything will
be fine. Not so. If we follow a substance-over-form rule, we will have anarchy in
financial accounting and reporting. Substance over form itself is so ambiguous that
if people are instructed to use that general rule instead of specific rules or standards,
then financial statements will become highly individualized. I will prepare financial
statements for my company the way I perceive the substance of things. You will
prepare yours your way. And soon the financial statements that are presented to
investors will have little comparability or consistency or understandability or
meaning.

By like token, some people say that preparation of financial statements ought to
be left, in large part, to the judgment of those who prepare and audit financial
statements. That we should have broad, general financial accounting and reporting
standards emanating from the FASB, with their implementation being left to the
issuer of the financial statement and its auditor. That approach will not work either.
A lot of people applied their judgment to accounting for ADC loans. That process
produced a judgmental mess that is costing untold, uncounted billions. Before
Accounting Research Bulletin 51 and FASB Statement 94 on consolidation were
issued, issuers of financial statements consolidated the financial statements of
whichever subsidiaries they wanted to. Before FASB Statements 8 and 52 on foreign
currency translation were issued, issuers of financial statements did their foreign

198 THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING

currency translation in a multitude of ways. Before FASB Statement 2 was issued,
some issuers of financial statements capitalized R&D costs, some capitalized selected
R&D costs, and others capitalized none. Before FASB Statement 5 was issued, some
issuers of financial statements charged to expense additions to catastrophe reserves
and so-called self-insurance reserves, and others did not. These examples prove that
broad general rules left to the judgment of issuers and their auditors have not
worked and will not work.

Currently, judgment is applied to the identification of impaired loans (the
“probable” criterion in FASB Statement 5) and to the measurement of losses on
impaired loans under Statement 5. We can see in current practice that the probable
criterion has not worked. Identification of impaired loans under that criterion is all
over the map, which produces wide non-comparability in financial statements. The
General Accounting Office has found that the criterion does not work. Likewise,
because Statement 5 does not address measurement of loan impairment, there is
wide non-comparability on that score in financial statements as well. At least the FASB
is working on the measurement aspects of loan impairment, but despite the warnings
of the GAO and others, the FASB is retaining the “probable” criterion.

In the area of impairment of cost of marketable debt and equity securities, FASB
Statements 12 and 60 require that the cost of marketable securities be written down
when a decline in value of the security is “other than temporary.” That literature
does not define “other than temporary,” so it is left up to the judgment of the issuer
of the financial statement.

Judgment is also applied to the identification and measurement of impairment of
the cost of long-lived assets, such as land, plant and equipment, and patents. The
questions the accountant asks are “will the carrying amount of the asset be recovered
through operations, and if not, what is the shortfall?” The Financial Executives
Institute and the Institute of Management Accountants have performed or
sponsored research work that has found wide variability in both the identification
and the measurement of impairment of the cost, or recoverability of the cost, of
long-lived assets, resulting in wide non-comparability in financial accounting and
reporting.

We can see, for example, that full-cost oil and gas companies must write down
the cost of their oil and gas assets whenever the so-called ceiling limitation is
exceeded by cost. Successful oil and gas companies do not have such a constraint,
and their capitalized costs sometimes exceed what would be allowed for a full-cost
company. We also see that some companies, but not full-cost oil and gas
companies, in identifying the impairment of the cost of assets and then measuring
that impairment, assume that the state of the world that surrounds the assets will
improve. That idle drilling rigs, for example, will go back to work drilling oil wells.
However, this assumption is not based on an assumption of a continuation of the
current price of oil of, say, $19 a barrel but an assumed increase to $25 or $30 a
barrel. That a plant producing at 45 percent of capacity will increase its production
runs to 85 percent of capacity or the assumption that consumers will buy more of
the product in the future despite prior reluctance. That buildings currently having

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 199

only 30 percent occupancy in two to three years will be 80 percent occupied, even
though there is seven to ten years of vacant space to be absorbed. That’s what we get
when we allow judgment to enter the accounting process in a major way;
management puts on its rose-colored glasses and the auditor is unable to prove that
his or her client is wrong.

Accountants and investors are currently seeing judgments being applied in
another area, namely the recognition of deferred tax assets. Under FASB Statement
109, the tax benefits of future tax-deductible amounts such as bad debts, warranties,
post-retirement benefits other than pensions, and operating loss carryforwards and
tax credit carryforwards are recognized as assets. If it is “more likely than not” that a
tax benefit, in whole or in part, will not be realized, a valuation allowance is
recognized that reduces the amount of the related tax asset. I recently saw the 1992
balance sheet of a registrant where the deferred tax assets are more than 400 percent
of shareholders’ equity. The deferred tax asset related just to healthcare benefits of
retirees from that corporation is more than 200 percent of shareholders’ equity. We
all know that those benefits will be paid many years in the future and will not
represent a tax deduction until paid. In a sense, this company’s balance sheet and
fortunes are based on anticipated future taxable income, and the company has
concluded that it is “more likely than not” that future taxable income is sufficient to
absorb tax deductions that arise in the future and those on hand today The auditor
is hard put to second-guess that judgment.

Well, so what, you may say. Ambiguous accounting standards have little or
nothing to do with auditor liability. I disagree. I think plaintiffs and their lawyers
clearly see that anytime an issuer or an issuer’s auditor is in the dock, that person is
vulnerable. That person is vulnerable because he or she relies on such fuzzy notions
as “probable” and “cost is recoverable through the ordinary operation of a going
concern,” realization of tax benefits is “more likely than not,” and market value
declines are “temporary.” Those terms, and others of similar ambiguity, are red
meat for the plaintiff’s bar. After an issuer has failed and it is found that the
historical cost of its fixed assets or patents cannot be recovered through a sale of
those assets, the issuer’s assertion that it thought it could recover its cost of those
assets on a going-concern basis is indeed weak. When an issuer’s receivables turn out
to be no good, but the receivables were thought not to be sour under a notion of
“probability,” the assertion that there was compliance with the literature is indeed
weak. When income tax benefits are ultimately not realized, using the literature as a
crutch will be of little help.

I think that it is in the best interests of investors to have financial statement
descriptions and amounts of assets that are relevant and that flow from simple and
unambiguous accounting standards. For example, if financial statement amounts
were required, in the case of assets, to be not in excess of market values, or fair
values, and not less than settlement amounts in the case of liabilities, these amounts
would be relevant to investors. Investors would more readily understand the
financial statement. Investors would be able to evaluate and compare the financial
position and results of operations of companies A, B, and C with greater ease and

200 THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING

with more certainty than is possible today. Likewise, it seems to me that, from the
standpoint of auditors protecting themselves from the risks of litigation, they too
should welcome simple and unambiguous accounting standards that produce
financial statements that can be easily understood by reasonable investors and by the
courts. Simple and straightforward standards may be the only way to end costly
legal debates over the reasonableness of judgment calls made, oftentimes, many
years in the past in a world of conflicting pressures and rapidly changing
circumstances.

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 201

31
Reporting by independent auditors on internal

controls
Adapted from a speech given by Walter Schuetze in 1993 at a

symposium sponsored by The CPA Journal on “In the Public Interest”

Both the Public Oversight Board and the AICPA have endorsed a number of
proposals to strengthen the profession. Among them is a recommendation that the
SEC require management and auditors of public companies to report on the
company system of internal control relating to financial reporting. The chief
accountant of the SEC responds.

According to the SEC’s Office of Public Affairs, more than 13,400 public
companies and 4,000 investment companies file various reports with the SEC. The
SEC requires that most of these reports include audited financial statements and that
those financial statements be made available to investors. The audit reports attached
to these entities’ financial statements enhance the public’s confidence in the
reliability of these statements, lessen the public’s fear that the financial statements
are incomplete or biased, and encourage the public to invest in securities issued by
public companies and investment funds. This concept of an independent audit of
the financial statements of enterprises that seek to raise money from the public is
one of the cornerstones of the Securities Act of 1933. Significantly, under the
Securities Act, an enterprise wishing to offer its securities to the public need not
engage counsel or have an underwriter, but it must have an independent auditor.
That independent auditor must audit and report on the registrant’s financial
statements and consent to the inclusion of his or her report in the offering document.

The commission requires audited financial statements for other purposes as well.
For example, 8,200 broker/dealers file reports with the commission. More than half
of these reports include audited financial statements, which are required to be
mailed to the broker/dealers’ customers. Audited financial statements in this
situation increase customers’ confidence in the creditworthiness and solvency of the
entity that holds their funds and securities and transacts their business.

The auditing function is thus of great importance to investors, the commission,
and the general process by which corporations raise capital and conduct their business
affairs.

Our capital market is the best in the world. I never cease to marvel at the capital-
raising and capital-allocation capability of our debt and equity markets. And audited
financial statements and related disclosures are the lubricant that allows the capital
market engine of this country to turn at very high RPMs. So, when the Public
Oversight Board says that the auditing profession is threatened by a lack of public
confidence litigation, or other risks, I am concerned, and when the profession
makes recommendations for improvements in financial reporting, I consider those
recommendations seriously

However, I am not a lawyer, so I cannot speak to the legal issues raised by the
profession, the Public Oversight Board, and others, such as joint and several liability
versus proportional liability, how contribution works or ought to work, or when or
how Rules 9 and 11 of the Federal Rules of Civil Procedure work or ought to work.

I am an accountant/auditor, so I want to address one aspect of the proposals
made by the Public Oversight Board and the AICPA’s board of directors that
concerns auditing and accounting, namely auditor reporting on registrants’ internal
controls related to financial reporting to the public. I am particularly interested in
statements that these bodies have made about how such auditor reports relate to
what is commonly referred to as “fraudulent financial reporting.” In addition, as I will
discuss later, I am concerned that investors and others may rely on such reports.

Who wants it?

The AICPA and the POB would have the SEC put in place a mandatory reporting
system so that the 13,400 public companies would have to state publicly whether
their internal controls over financial reporting are effective and their independent
auditors would have to opine, publicly, on that assertion by management. I think
most public company registrants would be opposed to such a requirement. When
the commission exposed that idea for comment in 1979 and again in 1988, it
received substantial adverse comment. More recently, public company registrants
formally or informally (mostly informally), have said they oppose the idea of public
reporting on internal controls by their independent auditors. The registrants are
saying that the additional costs involved would outweigh the benefits. Indeed, I
have heard some of those registrants say, informally, that there would be no benefit
whatsoever to the registrants or to investors. As well, I have not heard any private
user group arguing for public reporting on internal controls or indicating concern
over the magnitude or level of fraudulent financial reporting. For example, in its
July 1992 position paper entitled Financial Reporting in the 1990s and Beyond, the
Association for Investment Management and Research does not mention public
reporting on internal controls or the issue of fraudulent financial reporting.

Is there a cost benefit?

On the cost side, I have heard, again informally, that public reporting by
independent auditors on the effectiveness of registrants’ internal control systems

202 203

over financial reporting will involve additional costs to registrants. For smaller
companies, I have heard that the cost might be substantial, relatively speaking. So, if
one is favorably disposed toward such reporting, the age-old cost-benefit trade-off
would have to be considered.

One could argue that management and auditor reports on the quality of a
registrant’s internal control systems are desirable for two reasons: one, to prevent
fraudulent financial reporting; and, two, to improve financial reporting in general. I
have not heard much argument in favor of the second reason, namely to improve
financial reporting in general. The POB asserts, on page 53 of its Special Report,
that requiring auditors to assess management reports will lead to improvements in
systems, and I suppose that could improve financial reporting generally. Auditors
are now required to gain an understanding of the registrant’s internal controls, so
what the POB literally suggests is not new in that sense. Public reporting on those
controls would be new, however. The more registrants and their external auditors
think about, talk about, and work on improving internal control systems the better
those systems will probably become.

Aside from the POB’s statement and the position of the General Accounting
Office that led to the requirements for management and auditor reports on internal
control as part of the Federal Deposit Insurance Corporation Improvement Act of
1991, I have not heard any recent argument that public reporting by public companies
and their independent auditors will improve financial reporting in general. I
question whether the financial reporting by honest managements, who run the vast
majority of public company registrants, is going to be improved significantly by public
reporting on internal controls. However, I will reserve judgment on that reason for
public reporting on controls until I see or hear more evidence or argument

Will it prevent fraud?

The other reason for public reporting on internal controls is to prevent or deter
dishonest management from “cooking the books.” The AICPA has stated quite
plainly and directly that it is the independent auditor’s responsibility to detect such
fraud. The AICPA says, on page 2 of the White Paper:

Fraudulent financial schemes are the stuff of headlines and spicy news reports.
Fraud justifiably engenders public outrage. While few business failures involve
fraud, their corrosive effect on public confidence is widespread. The public
looks to the independent auditor to detect fraud, and it is the auditor’s
responsibility to do so.

The only argument by the board of directors of the AICPA for reporting on internal
controls over financial reporting is that it would reduce fraudulent financial
reporting. On page 4 of the June 1993 White Paper, the AICPA says “The internal
control system is the main line of defense against fraudulent financial reporting,”
and “The investing public deserves an independent assessment of that line of

204 THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING

defense.” The POB agrees. It says, on page 53 of its Special Report, that “improved
systems will make management fraud and manipulation of financial reporting more
difficult.”

After considerable informal discussions with practitioners, preparers of financial
statements, and other regulators, and a year and a half of reviewing accounting and
auditing enforcement cases as they wind their way to the commission, I question
whether public reporting on internal controls over financial reporting by registrants
and their independent auditors would reduce so-called fraudulent financial
reporting and litigation against external auditors.

The Treadway Commission found, in 1987, that fraudulent financial reporting
arises primarily because management is “cooking the books.” The POB, on page 49
of its Special Report, made a similar finding, to wit, “every fraudulent financial
statement for which an [independent] auditor has been held responsible was
prepared by executives who were intentionally committing a fraud, not only upon
their shareholders, investors and the markets, but also on the auditor.”

I agree that fraudulent financial reports arise principally when management of an
enterprise has deliberately falsified the facts by mis-stating assets, liabilities, equity, or
income. For example, management may report bogus receivables or non-existent
inventory as assets, or it may overprice existing inventory, or omit liabilities from
the balance sheet. These kinds of irregularity—namely lying and cheating by
“cooking the books”—may be difficult to identify if there is widespread collusion,
but a well-designed and well-executed audit provides the best means of detecting
these frauds. Indeed, the White Paper, as noted above, says that auditors have the
responsibility to find such fraud. No amount of reporting on internal controls will
ferret out any more fraud or provide any better techniques to find it than the audit
of the financial statements should have done in the first instance. Some argue that,
although reporting on internal controls may not uncover fraud, it will deter fraud by
having management and auditors focus on the internal control system and the
checks and balances placed on each management employee by such a system of
controls. However, I question how reporting on internal controls by independent
auditors is going to deter fraudulent financial reporting resulting from “cooked
books” when management was not deterred by the requirement for an annual audit
and was able in the first instance to conceal the fraud from the auditors during the
audit.

The problem of ambiguous accounting principles

Another, and more prevalent, cause of improper financial reporting is the use of
ambiguous accounting principles to overstate assets, equity, and income. Some
registrants use the lack of specific guidance in some accounting standards, or the
absence of a standard that directly addresses the registrant’s situation, to argue for
the presentation of uncertain facts in their most ambitious and favorable light
instead of presenting the facts in the financial statements in a neutral and objective
way. Auditors suggest that they cannot stop this kind of misconduct because, under

202 205

existing accounting principles, assets may be recognized even though there is no way
to audit or verify, with reasonable assurance, that any future benefit exists or that
the asset amounts will be recovered or realized. This kind of improper reporting
occurs, therefore, not because of a failure of auditors to discover crooked schemes
but because of a failure in the way accounting principles are written. No amount of
internal controls reporting can cure this problem.

The S&L crisis provides a prime example. The savings and loan crisis and certain
bank and insurance company failures went undetected, or at least unreported, by
the auditing profession because of such a failure of accounting principles. S&Ls
recognized interest income and fee income and related assets on acquisition,
development, or construction loans because revenue-recognition standards were so
general, so vague, and so judgmental that they amounted to no standards at all; and
this problem continues today. Even with SFAS No. 91, adopted in 1986, there is no
truly objective standard in place for recognition of fee income, or interest income
for that matter. In Statement 91, the FASB stated: “Deferred net fees or costs shall
not be amortized during periods in which interest income on a loan is not being
recognized because of concerns about the realization of loan principal or interest.”
The phrase “concerns about realization” is not a standard that can be applied
objectively. How can anyone audit the results of its application?

If it is believed that the practice regarding the recognition of fee and interest
income that went on in S&Ls is no longer going on, that belief is wrong. Insurance
companies that hold payment-in-kind (PIK) bonds or PIK preferred stocks, today,
with the blessing of their auditors, are recognizing interest or dividend income on
those assets even though no cash is being received and even though the market value
or fair value of the PIK bond or PIK preferred stock may be less than the cost plus
the amount of the so-called accrued interest or accrued dividend.

Observers of this scene also should not be lulled into believing the newly issued
SFAS No. 114, which deals with loan impairment, will necessarily improve the
matter. Unfortunately, the new standard suffers in some respects from the same lack
of bright lines as the previous practice. For example, in SFAS No. 114, the FASB
states that loan impairment should be recognized when it is probable that
contractual principal and interest will not be collected as stipulated in the loan
contract While Statement 114 is, in certain other respects, a significant improvement
over the prior literature, the probable standard in Statement 114 for the
identification of impaired loans is the same standard as was in effect when the S&L
problems arose. The probable standard is too judgmental and leads to wide non-
comparability among issuers’ financial statements.

By like token, under new SFAS No. 115, companies that invest in marketable
debt and equity securities are not required to write down the cost of their impaired
investment through income until any decline in value below cost is “other than
temporary.” Unfortunately, the standard does not define “other than temporary,” so
it is left to the judgment of the issuer of the financial statement. Auditors are not
able to enforce that standard, or at least have not enforced it, until the investee
company is draped in black crepe.

206 THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING

There is no written accounting standard at all for identifying and then measuring
impairment of cost of fixed assets and intangible assets. In practice, companies may
look at the undiscounted cash flows of assets to identify and measure impairment.
That seldom leads to write-downs of fixed assets or intangible assets short of a
decision to sell or abandon the asset. The cost of plant and equipment can sit in the
balance sheet for years even if fair value is below cost, even far below cost, because
management of the enterprise can assert, and generally does, that the state of the
world surrounding the assets is only temporarily depressed, that markets for the
company’s products will improve, or that the company will be able to reduce its
costs over time and that margins will improve. Thus cash flows will improve, and no
write-down is necessary.

I have suggested that the auditing profession go to the Financial Accounting
Standards Board and encourage it to write standards that provide numbers that can
be tested, verified, and reported on with a true sense of objectivity and reliability.

Reports by auditors regarding registrants’ internal controls, therefore, would not
address what I believe to be the basic cause of fraudulent financial reporting —
dishonest managements, or the application of subjective accounting principles.

The potential for over-reliance

In addition, there is a more fundamental concern I have with auditor reporting on
internal controls, which is the potential for over-reliance on the reports by investors
and the public generally. I have heard investors, and even members of Congress, say
that if a bank or savings and loan had better internal controls, they would not have
made loans that went bad. I have also heard some say that effective internal controls
result in more effective decision making by management, and others have gone so far
as to state that effective internal controls may prevent bad business decisions.

Unfortunately, the truth is that even companies with good internal controls make
mistakes. Internal controls related to financial reporting typically relate to the
recording of transactions, the authorization of transactions, and the safeguarding of
assets. No amount of internal controls will keep banks from making loans that later
go bad, prevent managements from entering into contracts that become loss contracts,
or make each decision to fund research and development pay off. Investors will be
disappointed. And, in their disappointment, investors and others may point to the
“clean” audit report on the effectiveness of the issuer’s internal controls and ask
“How could this happen?” Proponents of auditor reporting on internal controls
should make sure that there is an obvious and readily understandable answer to this
question before asking the commission staff to consider the imposition of more
costly reporting requirements on public companies.

Not a solution

I believe that auditor reporting on internal controls will not stop the crooks of the
world, who are going to make the financial statements say what they want them to

202 207

say regardless of the facts, and that auditor reporting on internal controls will not
solve the more pervasive and more important problem of managements pushing
pliable accounting standards. Further, while I believe that the proposition has yet to
be proved that auditor reporting on internal controls would result in a significant
improvement in financial reporting in general, I am certainly willing to have further
discussions on the issue.

Reproduced with the permission of the copyright owner; further reproduction
prohibited without permission.

208 THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING

32
A mountain or a molehill?

American Accounting Association, Accounting Horizons, Vol. 8, No. 1,

March 994, pp. 69–75

The commission has stated repeatedly that the independence of auditors, both in
appearance and in fact, is crucial to the credibility of financial reporting and, in turn,
the capital formation process.

However, I want to emphasize that these remarks represent my views and not
necessarily those of the commission or other members of the staff. This routine
disclaimer is perhaps more appropriate today because, in a moment, I am going to
discuss an independence issue that, as the commission’s chief accountant, I have
found personally very troubling when dealing with registrants’ accounting issues.

John L.Carey was, for many years, the senior staff officer of the American
Institute of Certified Public Accountants. In his 1946 book, Professional Ethics of
Public Accountants, Mr Carey wrote as follows about independence:

Only a moment’s reflection is necessary to perceive why independence is the
keystone in the structure of the accounting profession… The prime purpose
of…[the audit] opinion is to add to the credibility of the statements in the
eyes of outsiders who for one reason or another are interested in the financial
position and operating results of the business—for example, credit grantors,
stockholders, government regulatory agencies, potential investors and financial
analysts. Clearly they would set no great store by the certified public
accountant’s opinion or certificate if they were not confident of his
independence of judgment, as well as his technical competence. Technically
competent accountants may be employed by corporations as part of their own
staffs to keep accounts and make up their statements. The basic
differentiation between privately employed accountants and professional
practitioners is in their responsibilities, moral or legal, to the corporation or
the public, and in the extent to which their relationship may tend to influence
their judgment. In the last analysis, therefore, it is his independence which is
the certified public accountant’s economic excuse for existence.

Independence is an abstract concept, and it is difficult to define either generally or
in its peculiar application to the certified public accountant. Essentially it is a state of
mind. It is partly synonymous with honesty, integrity, courage, and character. It
means, in simplest terms, that the certified public accountant will tell the truth as he
sees it and will permit no influence, financial or sentimental, to turn him from that
course. Everyone will applaud this ideal, but a cynical world requires more than a
mere declaration of intent if it is to stake its money on the accountant’s word.
Therefore the profession has publicly laid its heaviest penalties on those who breach
the unwritten contract of independence and, in addition, it has proscribed specific
acts and models of behavior that might raise a question as to the independence of its
members. In other words, the rules not only provide for punishment of members
who are not independent but also prohibit conduct that might arouse suspicion of
lack of independence. Objective standards of independence have thus been
introduced into the code. It is not enough for the member to do what he thinks is
right. He must also avoid behavior that could lead to an inference that he might be
subject to improper influences. The accounting profession must be like Gaesar’s
wife. To be suspected is almost as bad as to be convicted.

Not long after I arrived at the commission in January 1992, the chairman of a
special committee of the AICPA asked for an appointment with my staff and me to
discuss auditor independence and, more specifically, to discuss a draft of a new
approach to determining auditor independence. The proposed approach would have
replaced the reasonable outside investor’s approach to independence with the
approach that a well-informed auditor would take to the question of independence.
The draft would have done away with the concept of auditors maintaining the
appearance of independence from their clients and would have focused solely on
independence in fact. That focus would have been achieved by eliminating much of
the specific guidance contained in current AICPA independence requirements.

My office reacted negatively to that draft. While I personally do not like the
present situation, where there is a large volume of detailed rules relating to
independence issues, principally issues arising out of family relationships between
auditors, auditing firms, and their audit clients, I do not see a practical way out of
this situation.

Moreover, I think that eliminating the concept of appearance of independence is
not viable. I personally would not favor its elimination. Prior commissions have
looked at the need for auditors to avoid being “suspected of improper influences,” to
use John Carey’s words, and concluded that requiring auditors not only to be
independent in fact but also to be independent in appearance was appropriate and
necessary if investors are to maintain confidence in the reliability of the financial
statements that daily provide the basis for investment and lending decisions.
Moreover, the Supreme Court emphasized appearance in the Arthur Young case in
1984 as follows:

The SEC requires the filing of audited financial statements in order to obviate
the fear of loss from reliance on inaccurate information, thereby encouraging

210 MARK TO MARKET ACCOUNTING

public investment in the nation’s industries. It is therefore not enough that
financial statements be accurate; the public must also perceive them as being
accurate. Public faith in the reliability of a corporation’s financial statements
depends upon the public perception of the outside auditor as an independent
professional.

The concept of auditor independence under federal securities laws was therefore
designed not only as a means to have better financial information reported to the
public but also to enhance investors’ perceptions regarding the reliability and
accuracy of that information. Starting from this vantage point, it is easily
understood why the staff resisted the approach taken by the AICPA committee that
independence issues should be viewed from the standpoint of a “reasonable
auditor.” To the staff, the key question is whether a reasonable investor, knowing all
the facts and circumstances, would consider the independent accountant to have
impartial and objective judgment on the questions confronting him or her during
the audit.

I want to turn now to an issue that has vexed and bewildered me since I came to
the commission two years ago. I refer to situations in which auditors are not standing
up to their clients on financial accounting and reporting issues when their clients
take a position that is, at best, not supported in the accounting literature or, at
worst, directly contrary to existing accounting pronouncements. To me, auditors
giving way to their clients, subordinating their views to those of their clients, raises a
nasty issue about independence both in appearance and in fact. In my opinion, an
auditor’s independence, whether called appearance or fact, is jeopardized as much
by his or her subordinating judgment about a financial accounting and reporting
issue as it is by investing in securities issued by a client, lending money to a client,
or borrowing money from a client—perhaps even more so. At least insofar as money
matters are concerned, if there was disclosure to the investor about that fact, then
the investor would be on notice and could be guided by the facts, although I would
not—definitely not—advocate such an approach. Not so with the subordinated
judgment, which is insidious. There is no way to communicate impaired or colored
judgment. No disclosure about it could ever be complete, or be trusted. Nor is there
any way for an investor to make judgments about the effect of impaired or colored
judgment on the part of the auditor.

In a speech in August 1992 to the annual meeting of the American Accounting
Association, I raised the issue of auditor independence in connection with what I
called “incredible” accounting proposals. By incredible accounting proposals, I
meant unsupportable conclusions regarding accounting issues that were being
proposed by registrants with the support of their auditors. These accounting
proposals, in my opinion, were wrong—not just debatable or arguable, but wrong.
Sometimes that support was in the form of a signed and unqualified opinion, and
sometimes that support was in written or oral presentations to the SEC’s staff before
the registrant’s financial statements were issued and the independent auditor
reported on those financial statements.

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 211

Some senior people in the profession privately suggested that I was making a
mountain out of a molehill in that 1992 speech. Some, including the AICPA’s
Public Oversight Board in its March 1993 special report entitled In the Public Interest,
suggested that a few engagement partners, on their own and without consultation
within their firms, might have inappropriately supported some liberal accounting
proposals. Others privately suggested that the few incredible accounting proposals
that were put forward to SEC staff had to be taken in the context of the thousands
of audits of public companies’ financial statements that take place every year, where
those companies’ financial statements are based on good and thorough applications
of generally accepted accounting principles.

It is true, as some have suggested, including the Public Oversight Board, that
many new and complex issues reach my desk because there is an honest difference
of opinion based on well-reasoned positions on all sides. In these cases, the staff
works with the registrants and their auditors to resolve those issues through
discussion, analysis of analogous literature, and compromise in many cases.
Addressing those kinds of issue is a challenging and interesting part of my job, and I
encourage registrants and their auditors to continue to bring these issues to the staff.
I am also aware, because I practiced in public accountancy for many years, of the
thousands of decisions that are made by auditors in their work where they insist on
adjustments to financial statements that reduce net assets and income or otherwise
insist on financial statement reporting and disclosures that managements of their
clients would rather not make—none of which is ever publicized.

However, there have been too many times where accounting arguments made by
registrants lack any reasonable foundation and, without being able to cite any
authoritative support for the registrant’s position, the auditor has acquiesced.

I was hopeful, after the August 1992 speech, that the profession would have
gotten the message and would have stopped the practice of supporting their clients’
incredible accounting proposals. My hopes have not been fulfilled, however. Since
then, we have had the following proposals, among others, by registrants and their
auditors. These have been supported not just by an engagement partner in a firm
without consultation within the firm but also by partners from the national offices
of the firms.

1 An airline company spends money to overhaul aircraft engines and airframes.
Some airline companies defer those overhaul costs and amortize the costs over
the estimated future benefit period. One such airline, with the support of its
auditor (actually two auditors, because one auditor was being succeeded by
another), proposed to classify as a current asset at the most recent balance sheet
date the portion of the deferred costs that was to be amortized to expense in the
following year. I cannot fathom how an equipment expenditure made in a
prior period can credibly be said to be a current asset at any subsequent balance
sheet date.

2 A registrant was committed to making cash payments under a non-cancellable
lease for the use of a building. For accounting purposes, the lease was classified

212 MARK TO MARKET ACCOUNTING

as an operating lease. The lease payments were based on a rental rate of, say,
$25 a square foot, which was the fair market rental when the lease was entered
into some years ago. Because of an oversupply of commercial real estate, the
market rental rate for comparable space over the remaining lease term is not
$25 but, say, $15 a square foot. The registrant was going to sub-let the building
to another company and receive from the sub-lessee so-called barter credits that
could be exchanged for, among other things, advertising by the company and
discounts from certain vendors. The company asserted that the value of the
barter credits for the advertising and the discounts was equal to the value of the
lease payments based on a rental rate of $25 a square foot. The registrant, with
the support of its auditor, therefore proposed not to recognize the loss of $10 a
square foot. The problem is the company’s assigning a value to the barter
credits based on the subjective nature of the value of the right to advertising
and trade discounts, rather than basing the value of the barter credits on the
more objective, and independently verifiable, current rental value for
comparable property—$15 per square foot. How could anyone credibly
support the argument that a sub-lessee would pay something of value worth
$25 a square foot when a fair value of the rent was $15 a square foot?

3 Registrant A acquired Company X. When A delved into Company X’s records,
it found that Company X’s liabilities for certain payroll taxes were understated.
A and X, with the auditor’s support, proposed that adjustment to X’s payroll
tax liability not be reported in X’s income statement in periods prior to the
business combination but be included in the adjustments arising in purchase
accounting. How could anyone credibly support a proposal that X’s payroll
costs did not need to include the necessary payroll taxes in X’s income statements
for periods prior to the business combination?

4 Company H acquired majority, but not total, ownership of Company Z.
Company Z had outstanding stock options held by employees, which if
exercised would have had adverse tax consequences for Company H. The
options were deep in the money and were vested and exercisable. Company H
wanted to enter into new contracts with Z’s employees, which would have
postponed exercise of the options and protected the amount by which the
options were in the money if the value of the underlying stock declined.
Companies H and Z argued, with the support of their auditor, that the terms
of the outstanding options had not been changed, no new measurement date
had occurred under Accounting Principles Board Opinion 25, and therefore no
amount of compensation cost need be recognized. How can anyone credibly
argue that a new agreement that protects an employee holding a stock option
deep in the money from any decline in the price of the stock is not a new stock
option agreement that triggers a new measurement date and consequent
compensation cost?

Those are a few specific registrant examples, of which there are more. If these were
the only examples, they perhaps could be excused as anomalies. But there are other

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 213

cases that are more broadly applicable, and they involve many companies. And, in
these cases, it is again clear that the auditors’ actions are not individual engagement
partners acting on their own but that the actions are undertaken with the
knowledge of the national offices of the firms. For instance, last year the FASB’s
staff and the SEC’s staff had to force prompt consideration of the issue of “funded
catastrophe covers” by the Emerging Issues Task Force, which is reported in EITF
Issue 93–6. This issue involves companies in the property casualty industry paying
reinsurers premiums for catastrophes such as Hurricane Andrew and Typhoon Iniki
in years before, during, and after the year of the catastrophic event. The reinsurance
contract was such that, if no catastrophe happened, a portion of the amount of the
premium, say, 85 percent, went from the reinsurer back to the insurer in the form
of cash. If a catastrophe happened, the reinsurer paid the loss but then the insurer
had to repay the amount of the loss to the reinsurer plus interest. The insurers were
recognizing expenses for the catastrophe losses in years before the catastrophic
event, the year of the event, and years after, as premiums were paid to the
reinsurers, instead of in the year or quarter in which the catastrophe happened, all with
the concurrence of their auditors. FASB Statement 5, Accounting for Contingencies,
issued in 1975, specifically deals with the accounting for such events and says that a
loss should be recognized in expense in the year in which the event happens—not
sooner or later. A number of registrants have changed their accounting as a result of
the FASB staff’s and SEC staff’s intervention. This episode led to an article in The New
York Times on 5 September 1993 entitled “Cooking books: how hurricane losses
vanished.” The article said, in part:

How, you might wonder, could any companies have gotten away with this
obvious phoney accounting, given that all the Big 6 Accounting firms agree it
is wrong. In fact, auditors from each of those firms accepted the accounting,
although some tried to resist and allowed slightly less liberal accounting.

“When there is somebody down the street who will say yes,” commented
one accountant who studied the issue, “other firms find themselves under
enormous pressure to also say yes.”

I do not see how registrants and their auditors credibly could argue that they did
not have to pay attention to the official accounting literature.

Another issue arose last year that affected many companies. Our staff began to
question the rates that registrants were using to discount their estimated future cash
payments for pensions and healthcare benefits for retirees. The official literature
explicitly requires that the discount rate be based on the current level of interest
rates, and the literature refers to the yield on high-quality corporate bonds. Many
registrants were instead using old, outdated interest rates that were much higher
than current rates on high-quality corporate bonds. Consequently, their pension and
healthcare benefit obligations were significantly understated. As our staff got into
the issue, it became clear that many registrants, without objection from their
auditors, were not following the authoritative literature in selecting their discount

214 MARK TO MARKET ACCOUNTING

rates. It took a letter from the chief accountant to the FASB’s Emerging Issues Task
Force dated 20 September 1993 to challenge both registrants and their auditors to pay
attention to the literature. In many cases, the effect of not following the literature
was, without any doubt, material. The press has covered this issue extensively in
recent months. USA Today, on 18 November 1993, wrote as follows, in part, about
corporations using a too high rate to measure pension liabilities:

It’s an open secret in the pension field that companies have been using out-of-
date assumptions about interest rates, says Gordon Webb, a pension
consultant at Foster Higgins in San Francisco. “Employers are playing it fast
and loose, and the auditors are letting them get away with it,” he says.

There are now a substantial number of companies that will be changing their
discount rates as a result of the SEC staff’s intervention. This non-compliance with
the literature comes on the heels of what we observed in 1992, when many banks,
thrifts, and insurance companies, with the concurrence of their auditors, were not
following the literature in classifying their debt securities holdings as between “held
for investment” and “held for sale,” which was corrected only through SEC staff
intervention. How can registrants and their auditors ignore the literature and then
expect investors, regulators, Congress, and the public generally to put credence on
what they say?

It also appears to me, and other outside observers, that CPAs may have become
cheerleaders for their clients on the issue of accounting for stock options issued to
employees. (I should make it clear here that the commission has not considered the
issue of the accounting for stock options issued to employees.) In 1978, in response
to a proposed interpretation by the FASB of the existing accounting rules for stock
options granted to employees, six of the Big Eight accounting firms wrote to the
FASB suggesting that the board reconsider the accounting rules for stock options
granted to employees. In the early and mid-1980s, the AICPA, through its
Accounting Standards Executive Committee, twice asked the FASB to re-examine
the accounting for stock options issued to employees. In 1982, the AICPA said “the
principles [of Accounting Principles Board Opinion 25] should be changed so that
compensation expense is recognized for most plans.” In 1984, the AICPA said
“AcSEC is pleased that the FASB has undertaken a project on a broad
reconsideration of the principles that underlie APB Opinion 25… AcSEC believes a
major change in accounting for compensation plans is necessary.” The AICPA, in
the 1984 letter, went on to say that compensation cost should be based on the fair
value of the option at the grant date and recommended that the so-called minimum-
value method be used to measure the value of the option.

In 1984 and 1985, in response to the invitation to comment that began the
FASB’s reconsideration of the existing accounting rules for stock options granted to
employees, all except one of the then Big Eight accounting firms wrote to the FASB
supporting (1) reconsideration of the accounting rules and (2) a charge to
compensation cost/expense for all options granted to employees.

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 215

But, in February 1993, even before the FASB issued its exposure draft on the
subject on 30 June 1993, all of the Big Six accounting firms joined forces with
certain members of industry and a group of users to recommend to the FASB that
there be no formal recognition for the cost of stock options. (I understand that the
AICPA’s Accounting Standards Executive Committee recently changed its mind
and now will recommend to the FASB that there be no recognition for the cost of
fixed stock options.) The Big Six accounting firms did not, in February 1993, offer
an explanation for their change of mind. I would be the first to say that anyone
could change his or her mind. I have changed my mind on several accounting issues
over the years. But I think that the public deserves an acknowledgment of that
change of mind by the firms and the reason why Such a change in position, without
a corresponding change in the underlying concepts and issues that led the firms and
the AICPA initially to support the FASB’s project, has left some members of the
public with the impression that the switch was in response to the fear of losing
clients or other forms of retaliation. I do not know if this is true. However, if public
companies are pressuring their outside auditors, and the Accounting Standards
Executive Committee of the AICPA, to take particular positions on financial
accounting and reporting issues, and outside auditors are subordinating their views
to their clients’ views, can the outside auditor community continue to claim to be
independent? Could continuation of such a trend be anything other than an
invitation to Congress, the SEC, and other regulators to regulate more heavily, and
directly, the auditing profession in particular and financial accounting and reporting
in general? Could continuation of such a trend lead investors, particularly
institutional investors, to find alternative ways to corroborate issuers’
representations in their financial statements?

The independence rules promulgated by the AICPA and the SEC principally
address the appearance of independence because it is impossible to regulate an
individual’s state of mind. However, the independent mindset is the most basic
independence requirement. The advocacy of weak and unsupported client
accounting positions speaks loudly about independence in fact. The preceding
examples have been gleaned from the numerous issues that have been considered by
the Office of the Chief Accountant since August 1992. In that context, the specific
and general examples cited represent a small—some might even argue, insignificant
—number of exceptions to the generally outstanding manner in which the
accounting profession carries out its duties as “public watchdog.” However,
individual practitioners and firms need to be mindful that the number of such
instances that may poison the well with regulators, legislators, investors, and the
general public is small indeed.

I make these comments with a heavy heart. As many of you know, these comments
do not come from an ivory tower. I have lived and worked in the accounting
profession for more than 30 years. I know the realities of saying “no” to a client. I
know the disappointment some clients express when the auditor makes a decision to
support an accounting proposal that may reduce those clients’ reported earnings. I
know the long and often heated telephone calls and client visits, the emotional

216 MARK TO MARKET ACCOUNTING

strain, and the financial cost that follow such decisions. But I also know the rewards
—a clear conscience, not having to worry about losing lawsuits based on the merits,
and pride in the profession and the credibility of financial accounting and
reporting. I hope that the profession and registrants will, through self-restraint, take
a fresh look at these independence issues and, as John Carey suggested, let nothing
stand in the auditor’s way of telling the truth as he or she sees it.

Reproduced with permission of the copyright owner; further reproduction
prohibited without permission.

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 217

33
Comments on certain aspects of the special

report by the AICPA’s Public Oversight Board
of 5 March 1993

Address to University of Southern California, SEC and Financial

Reporting Institute, 27 May 1993

The major firms in the public accounting profession say that they are in a crisis, a
liability crisis. They say that when there is a business failure, they are being asked by
the government and by the courts to pay huge amounts of money to the government
or to investors. Moreover, they say, they are being asked to pay, and forced to pay,
amounts of money that are not in proportion to any fault that they may have had in
reporting on the correct or incorrect financial statements of the business that failed.

Representatives of a number of accounting firms asked the Public Oversight
Board of the American Institute of Certified Public Accountants1 to consider
whether that board could support the profession’s efforts to obtain relief from what
the profession believes to be an excessive burden of litigation. In studying this issue,
the POB became concerned that attacks on the accounting profession from a variety
of sources suggested a significant public concern with the profession’s performance.
The POB has therefore issued a report addressing more than the isolated issue of
litigation reform. The report includes twenty-five recommendations that the POB
believes, if implemented, would improve the usefulness and reliability of financial
statements and enhance the auditor’s ability to detect fraud and other illegal acts.2

It is time to begin the discussion and debate about the recommendations in the
POB’s special report, and I will address here today the three recommendations that
are addressed to the Securities and Exchange Commission. I wish to make it clear that
I have not discussed my analysis with any of the commissioners and that the
commissioners have reached no conclusions, tentative or otherwise, about the
POB’s recommendations. What follows is my analysis and very, very tentative
conclusions, and mine alone. I would not be surprised if I were to change my mind
about these matters as this discussion and debate goes forward in the coming months.
As is often the case, as I learn more about something and as I think more about it, I
change my mind.

Recommendation II-1: the SEC should amend its rules to require SEC registrants
to disclose whether their auditors have had a peer review, the date of the most
recent peer review, and its results.

In 1985, the commission proposed such disclosure as part of a comprehensive
review of the proxy rules: Securities Act Release No. 6592, Exchange Act Release
No. 22195 (1 July 1985). Specifically, the proposal would have required each
registrant’s proxy statement to include:

(i) a statement of whether or not the principal accountant…is a member in a
professional organization which has both a peer review program and
independent oversight function, both of which are subject to review by the
Commission and (ii) if such a member, a statement whether or not the
principal accountant has had such a peer review, and if so the date of the
most recent peer review report.

While the proposed disclosure did not address the results of the peer review, the text
of the proposing release stated:

(ii) if the results of the peer review were other than unqualified, however,
registrants would need to consider whether they should disclose the nature of
any qualifications and the status of the principal accountant’s efforts to
correct deficiencies which were the basis for such qualifications. Such disclo
sure might be material to an informed voting decision, where, for example,
the deficiencies uncovered were of a significant or pervasive nature and have
not yet been corrected.

A footnote at the end of this paragraph stated:

See Rule 14a-9(a), which prohibits, inter alia, the use of proxy material that
“omits to state any material fact necessary in order to make the statements
therein not false or misleading.”

Thirty-eight commentators addressed the proposal. Five supported the proposal,
thirteen suggested modifications, and twenty opposed it. Those suggesting
modifications, and those opposing the proposal, stated that they were concerned
with putting such information about the accountant in the registrant’s “liability
document.” They stated that the proposal opened questions regarding a registrant’s
duty to inquire, verify, and evaluate any information provided by the accountant
regarding its participation in the peer review program, its categorization of the peer
review report, and the status of the accountant’s efforts to correct deficiencies.
Commentators emphasized that registrants were not experts in performing peer
review evaluations. They said that the proposal would place a “compliance burden”
on registrants without providing an equivalent benefit to security holders. The
American Bar Association, in its opposition to the proposal, said that requiring

MARK TO MARKET ACCOUNTING 219

registrants to make judgments on disclosure of deficiencies noted in peer review
reports, and to ascertain the status of corrective efforts by their accountants,
“imposes burdens on registrants that border on the unseemly.”

Other positions advanced by several commentators to show that the proposal
would be an inappropriate burden on registrants were that (1) the proposal was
superfluous (as most SEC registrants already had auditors who were members of the
SECPS) and that (2) others were in a better position than registrants to review the
peer review process. In addition, other commentators said that the disclosure was an
inappropriate method of coercing membership in the SECPS, especially because, in
their opinion, SECPS members were no better qualified to perform audits than non-
members. Others said that the disclosure might give shareholders an unwarranted
sense of confidence. Still other commentators said that the costs of membership in
the SECPS were material to small and medium-sized firms and that the proposal
therefore tipped the “competitive balance” in favor of large firms.

I question what benefit investors and potential investors would get from such a
disclosure standing alone. Should the disclosure be accompanied by any
“comments” that the reviewer had on quality controls of the firm being reviewed?
Suppose the peer review report was not unqualified and that fact was disclosed—
what would investors do then? Should the disclosure be accompanied by additional
disclosure about litigation against the firm generally or about SEC Rule 2(e)
proceedings against the firm or certain of its partners?

Recommendatian V-10: the SEC should require registrants to include in a
document containing the annual financial statements a statement by the audit
committee (or by the board if there is no audit committee) that describes its
responsibilities and tells how they were discharged. This disclosure should state
whether the audit committee members (or, in the absence of an audit committee, the
members of the board): (1) have reviewed the annual financial statements; (2) have
conferred with management and the independent auditor about them; (3) have
received from the independent auditor all information that the auditor is required to
communicate under auditing standards; (4) believe that the financial statements are
complete and consistent with information known to them; and (5) believe that the
financial statements reflect appropriate accounting principles.

The POB report cites the 1987 report of the National Commission on Fraudulent
Financial Reporting (the Treadway Commission) as support for this
recommendation. In line with the Treadway Commission’s “tone at the top”
approach, the POB report states, “The responsibility of corporate boards and their
audit committees for the integrity of management and financial reports should be
pinpointed and reinforced and the appropriate authorities should adopt measures to
assure that it is.”3 The POB states, “in too many instances the audit committees do
not perform their duties adequately and in many cases do not understand their
responsibilities.”4 The proposed disclosure is intended to encourage audit
committees (or boards) to fulfill the listed responsibilities. The POB cites the recent
compensation committee reports as a precedent for this kind of reporting.

220 THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING

As noted by the POB, the Treadway Commission similarly recommended that all
public companies should be required by SEC rule to include in their annual reports
to stockholders a letter signed by the chairman of the audit committee describing
the committee’s responsibilities and activities during the year.

When then Chairman Ruder testified before Congress on the Treadway
recommendations in 1988, he noted that companies that have securities registered
under section 12 of the Exchange Act are subject to the commission’s proxy rules,
and that these rules require disclosure concerning the existence of and the functions
performed by audit committees. Specifically, pursuant to item 7(e) of Schedule
14A, a company making a proxy solicitation must state whether it has an audit
committee, and if so, must “identify each committee member, state the number of
committee meetings held…during the last fiscal year and describe briefly the
functions performed” by the audit committee. Chairman Ruder’s testimony noted
that the Treadway Commission report acknowledged that certain of the information
in the proposed audit committee letter would duplicate existing proxy statement
disclosures. The testimony then states, “The Commission believes that the proposed
audit committee letter would not provide investors with significant additional
information and is thus unnecessary.” The disclosure described by Chairman Ruder
continues to be required today.

Other information about audit committees, not mentioned in Chairman Ruder’s
testimony, that must be disclosed in commission filings includes whether a registrant’s
audit committee recommended or approved a change in accountants, and whether
it consulted with the former accountant concerning disagreements with management
and certain other matters.5

The POB’s analogy to the compensation committee report may not be on all
fours. The compensation committee report disclosure item does not require any
particular actions or procedures. It is designed to require a description of the rationale
of the compensation committee for the reported compensation and its relationship
to company performance. Even so, it attracted negative comment.6

The audit committee disclosure proposed by the POB, essentially requiring the
performance of designated procedures, surely would be more controversial than the
compensation committee disclosure.

The POB admits that the proposed disclosure is designed primarily for its
behavioral impact and not for the relevance of the information being disclosed.7 I
understand that courts have generally opposed the commission’s imposing such
corporate governance standards and suggested that how audit committees operate
should remain a matter of state law. The information already required to be
disclosed about audit committees, the commission’s decision not to implement the
Treadway recommendation in 1988, and the anticipated states’ rights issues
involved, will have to be reviewed carefully before the commission makes any
determination on whether to proceed with this recommendation.

Recommendation V-12: the SEC should require registrants to include in a
document containing the annual financial statements: (1) a report by management
on the effectiveness of the entity’s internal control system relating to financial

MARK TO MARKET ACCOUNTING 221

reporting; and (2) a report by the registrant’s independent accountant on the
entity’s internal control systems relating to financial reporting.

On 19 July 1988, the commission published for comment proposed rules that
would have required a report from management on its responsibilities for the
registrant’s financial statements and internal controls to be included in
annual reports to shareholders, in forms 10-K, and in investment companies’
semiannual reports.8 The commission received approximately 190 comment letters
in response to this release. A review of these letters indicated that a majority of the
commentators supported a management report on its responsibilities for the
preparation of the registrant’s financial statements and for establishing and
maintaining a system of internal controls for financial reporting.

However, reservations were expressed about other aspects of the commission’s
proposed management report. Commentators noted concerns regarding proposals
for a management assessment of the effectiveness of the registrant’s internal
controls, disclosure of how management has responded to significant
recommendations concerning the registrant’s internal controls made by its internal
auditors and independent accountants, and a requirement that the report be signed
by the registrant’s principal executive, financial, and accounting officers. Some
commentators questioned whether a report noting deficiencies in a registrant’s
internal controls would constitute an admission of a violation of the Foreign
Corrupt Practices Act (FCPA). Commentators also expressed concerns about the
potential for over-reliance by investors on the proposed report. On 16 April 1992,
the commission withdrew this proposed rule from its Regulatory Flexibility Act
agenda.9

Although this was not included in the proposed rule, the commission requested
specific comments on whether independent accountants should be required to
report directly on either the registrant’s internal controls or the proposed
management report. Almost all of the commentators addressing this issue opposed
such direct auditor reporting.10

Under the commission’s 1988 proposal, the management report would have been
included in an annual report of the registrant containing audited financial
statements. Thus the registrant’s independent accountant would have been
required, under current auditing standards, to read the management report and to
inform the registrant of anything in that report that the accountant concluded
constituted a material inconsistency with the financial statements or a material mis-
statement of fact or material omission. In the event that an issuer failed to correct such
mis-statements or inconsistencies, Statement on Auditing Standards No. 8 would
have required the auditor to take appropriate steps to ensure disclosure of its
concerns or, failing that, to consider other actions including withdrawal from the
audit engagement. If the audit engagement ended (through the auditor’s resignation
or discharge), the accountant’s concerns would have been reported publicly
pursuant to the disclosure requirements regarding changes in accountants included
in form 8-K and item 304 of Regulation S-K.11

222 THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING

Legislative proposals have been made in this area. On 5 October 1990, the US
House of Representatives passed an amendment to the then proposed
Comprehensive Crime Control Act of 1990 that, among other things, would have
required virtually every issuer subject to the reporting requirements of the Securities
Exchange Act of 1934 to set forth, in its form 10-K and annual report to
shareholders, (1) a description of management’s responsibilities for maintaining an
adequate internal control structure and (2) an assessment of whether that structure
reasonably assures the preparation of annual and quarterly reports in conformity
with generally accepted accounting principles. Management would also have been
required to disclose the existence of any material weakness in the control structure
that had not been substantially corrected as of the date of filing the annual report.
Under this proposed amendment, the issuer’s independent public accountant would
have examined and reported on management’s assessment of its internal control
structure, and the independent accountant’s opinion would have been included in
the issuer’s annual reports. However, this amendment was not made part of the
enacted Crime Bill.

In 1991, a bill was introduced in the US House of Representatives that, if
enacted, would have mandated an SEC study on the extent to which companies are
complying with the accounting and internal control provisions of the FCPA. The
required study would also have examined the extent to which registrants’
compliance with the FCPA, and the reliability of registrants’ financial statements,
would be improved by a requirement for annual public reports by managements and
registrants’ independent accountants on the adequacy of registrants’ internal control
structures. However, this bill was also not enacted.

Finally, the Committee of Sponsoring Organizations of the Treadway
Commission has completed a study that is intended to provide guidance in
conducting assessments of public companies’ internal control structures, entitled
Internal Control—Integrated Framework.

I am of two minds about an independent auditor’s reporting on management’s
assessment of its internal controls. I recognize the argument that the more
managements, audit committees, internal auditors, and external auditors think about,
talk about, and focus on internal controls, the better the internal controls are likely
to be and will become. That argument says that management should report publicly
about the effectiveness of the registrant’s internal controls and that the external
auditor should report publicly about management’s representations about the
effectiveness of the registrant’s internal controls.

The commission’s experience in requiring auditor reports on the internal controls
of certain broker/dealers,12 transfer agents,13 and investment companies14 would
support the argument for mandatory internal control reports for public companies as
well. However, the reports that are currently required have been motivated primarily
by the fact that these entities are custodians of their customers’ funds and securities,
and by the need to ensure that these funds and securities are safeguarded. In a sense,
all public companies are custodians of their investors’ funds, and it could be argued
that the same type of report should be required of all registrants.

MARK TO MARKET ACCOUNTING 223

However, I know that there are in this world a certain number of people with
dishonest bones in their bodies. All the reporting on internal controls in the world is
not going to stop those people from defrauding the public and, in the process, the
external auditor as well. Invariably, there are going to continue to be cases where,
despite reports on internal controls by external auditors, inventories are missing,
receivables are bogus or not good, and not all the accounts payable or other liabilities
are recorded in the books and recognized on the face of the balance sheet. When
those cases happen, and they will, the public’s expectations will be dashed.

In addition, I am told that there will be a cost, perhaps a significant cost, to
registrants, especially smaller ones, to get their external auditors to report publicly
on their internal controls. So I do not know which way to lean.

The POB should be commended for the hard work and insight that is reflected in
the special report. The issues covered in the report, although not necessarily new,
are important not only to the accounting profession but also to preparers and users
of financial statements and to the legislators, courts, and regulators that administer
and enforce the financial reporting system in this country. Without any prediction
on what actions, if any, the commission may take, I hope that the report will
continue to fuel the public debate on these issues. I look forward to hearing your
thoughts throughout this and other conferences, in articles in the press, and in other
forums. Thank you.

Notes

1 The AICPA determined in 1977 that public confidence in the profession’s, then newly
established, peer review program would be increased if an independent oversight board
composed of prominent individuals oversaw and reported on that program. The
Public Oversight Board (POB) was created to serve this purpose. The POB also
reports on other matters bearing on the integrity of the audit process. The POB
maintains its independence from the AICPA by selecting its members and staff, setting
their compensation, and choosing its own chairman. Current members of the POB are
Chairman A.A.Sommer, former SEC commissioner; Robert Mautz, professor emeritus
of the University of Illinois and the University of Michigan; Robert Froehlke, former
Secretary of the Army; Melvin Laird, former Secretary of Defense; and Paul
McCracken, former chairman of the President’s Council of Economic Advisers.

2 Public Oversight Board, In the Public Interest: A Special Report by the Public Oversight
Board of the SEC Practice Section, AICPA (5 March 1993), at 1.

3 POB report, at 49–50.
4 POB report, at 50.
5 Item 304 of Regulation S-K, 17 CFR 229.304.
6 See Securities Act Release No. 6962 (16 October 1992).
7 See generally, POB report, at 49–51, which states, among other things, “In the

Board’s opinion, audit committees should assume defined responsibilities, as outlined
in the recommendation set forth below.”

8 Securities Act Release No. 6789 (19 July 1988) [53 FR 28009].
9 See Securities Act Release No. 6935 (24 April 1992) [57 FR 18424].

224 THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING

10 Congressional testimony by the commission in February 1993 notes that mandatory
auditing of internal controls could result in “enormous costs with relatively few real
benefits.” Statement of Chairman Richard C.Breeden before the Subcommittee on
Telecommunications and Finance of the House Committee on Energy and
Commerce, Concerning H.R. 574, The Financial Fraud Detection and Disclosure
Act, at 35 (18 February 1993).

11 17 CFR §229.304. See Financial Reporting Release No. 31 (12 April 1988) [53 FR
12924].

12 17 CFR §240.17a-5(j).
13 17 CFR §240.17Ad-13.
14 Form N-SAR, sub-item 77B.

MARK TO MARKET ACCOUNTING 225

34
Enforcement issues

Good news, bad news, Brillo pads, Miracle-Gro, and
Roundup

Address to Twenty-sixth Annual AICPA National Conference on SEC

Developments, Grand Hyatt Hotel, Washington, 8 December 1998

There is nothing new under the sun on the accounting side at the Division of
Enforcement. Over the years, I have heard every chief accountant of the division
speak at forums like this one, and they all said the same things. I have been the chief
accountant of the Enforcement Division since November 1997, and I have seen
nothing new. There are only so many ways to cook the books. I, too, am going to
sound like a broken record.

I bring both good news and bad news. I will start with what should be good news.
From my perspective as chief accountant of the Enforcement Division, looking only
at our statistics, financial accounting and reporting would appear to be in good shape.
I say this based on the number of financial accounting and reporting cases that the
commission completes every year. These are the cases involving accounting issues,
financial statement disclosure issues, MD&A disclosure issues, auditing issues, and
auditor independence issues. These cases do not involve insider trading, stock price
manipulations, yield burning, or supervision of registered representatives.

Our statistics show that the commission completes about 100 accounting cases a
year. If I divide 100 cases by 16,000 commercial and industrial public companies
who file documents with the commission, the result is about 0.6 percent. A very
small percentage. To be sure, the percentage is not Six Sigma, but nonetheless it is
very small. What that statistic taken in isolation says to me is that, by and large, the
issuer/participants in our vast public marketplace are conforming to the rules.

The value of 0.6 percent would be cut about in half were I to include broker/
dealers and investment companies in the statistics. In addition to the 16,000 public
company issuer/registrants that file financial statements and audit reports with the
SEC, there are about 7,000 broker/dealers and about 7,000 investment companies
that also file financial statements and audit reports with the SEC. So if I add 7,000
broker/dealers and 7,000 investment companies to the 16,000 issuer/registrants, the
total is about 30,000. Then, 100 cases divided by 30,000 opportunities equals 0.3
percent. Over the years, we have had only a limited number of accounting cases

involving broker/dealers and mutual funds. I think that it is instructive to observe why
that is. I think that there are not many cases involving broker/dealers and investment
companies because those companies mark their assets to market. Many of our
accounting cases not related to broker/dealers and investment companies involve
accounting for various kinds of deferred costs. One cannot mark to market a cost.
One can mark to market only something that has value in the marketplace.

While the above should be good news and welcome news, I have bad news. Bad
news that makes me suspect that the inferences I draw from the numbers above are
incorrect. In the 13 July 1998 issue of Business Week, there is a special advertising
section reporting on the magazine’s Seventh Annual Forum of Chief Financial
Officers. The 160 delegates at the forum were polled electronically and
anonymously on twenty-seven questions. Question 10 reads as follows:

As CFO, I have had to fight off other executives’ requests that I misrepresent results:

1 Yes, it has happened, but I said “no” and fought them off.
2 I yielded to the requests.
3 No such pleas ever received by me.

Sixty-five of the 160 CFOs responded to that question. Listen now to the responses.
Only twenty-one CFOs, or one-third of the sixty-five respondents, said they had
not been asked to misrepresent results. But forty-four of the sixty-five said they had
been asked to misrepresent results. Thirty-six of those forty-four fought off the
requests, but eight of the respondents said that they had yielded to the requests to
misrepresent results. I repeat: 67 percent of the CFOs had been asked to
misrepresent results, and 18 percent of those who were asked did so. Those statistics
are staggering. Given that we have about 16,000 commercial and industrial
companies as issuer/registrants, and assuming that the answers given of the sixty-five
respondents are representative of the entire population, this means that in almost 11,
000 cases CFOs were asked to misrepresent results, and in almost 2,000 cases the
CFOs yielded to the request to misrepresent results. Those statistics boggle my
mind.

Let me raise with you another troublesome development regarding financial
accounting and reporting. While I have not counted the cases, I see, just by reading
the newspapers, that some issuer/registrants are turning not to their regular auditors
but to “forensic” auditors from other firms when questions are raised about the
issuer’s financial statements. The scenario is as follows: The issuer says in a press
release that it has uncovered facts that indicate previously issued financial statements
may be wrong. The issuer’s audit committee then retains counsel to investigate.
Counsel retains “forensic” auditors to help in the investigation. The forensic
auditors are a different firm from the issuer’s regular auditors. The forensic auditors
then take their Brillo pads and scrub the issuer’s balance sheet until it looks like a
newly minted copper penny, and the restate-ments to assets, liabilities, equity, and
income are the size of an elephant. The question is: which firm did the real audit?
Which firm’s partners and staff did not have their objectivity clouded or enveloped

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 227

by relationships developed at picnics or golf outings or at sports events with their
clients? Which firm’s partners and staff did not have their skepticism dulled by the
fact that a former partner of the audit engagement partner is now the client’s CFO?
That the audit partner and the CFO are also doubles partners at the tennis club on
Saturday mornings?

Which brings me to the issue of fraternization between auditors and their clients.
It appears to me that some auditors and their families, through social contacts, are
getting so close to and so involved with their clients and their clients’ families that a
disinterested observer would question whether the auditor’s objectivity had not been
clouded or perhaps even enveloped. Let me give you two examples. In Business Week
(23 February 1998), there is an article that talks about auditors and their families
having social contacts with their clients and their clients’ families through such joint
activities as picnics and baseball games.

The Enforcement Division recently came across an audit planning memorandum
of a Big Five firm wherein social events between the auditor and client are explicitly
set forth. I quote from that memorandum (I have not used the names of sports teams
actually used in the memorandum but have substituted other names).

Summer and Other Social Events

• Golf
• The University of Texas football games (Oklahoma, Texas A&M, and Arkansas)
• NCAA Basketball final four tickets
• San Antonio Spurs tickets
• Houston Astros tickets
• Shopping

I wonder what “shopping” means. Alpaca sweaters? Golf clubs? Bally leather jackets?
I wonder how investors or potential investors would react if they were aware of these

facts. Would investors believe that the auditor’s objectivity is not affected when the
auditor and his or her family are engaged in periodic baseball games and picnics
with the client and the client’s families? Would investors believe that the auditor’s
objectivity is not affected if the auditor and client personnel regularly attend
sporting events together? Co shopping together? Whether paid for by the auditor or
paid for by the client? Would investors perceive that gift giving, whether from
auditor to client or client to auditor, can go on for very long without compromising
the auditor’s objectivity? How would an underwriter who is about to underwrite an
offering of $500 million of stock of that company react to these facts? A mutual
fund investment manager who is about to invest $100 million in the stock of that
company? Query: should auditors have to follow the same rules with respect to their
public company audit clients that I as an employee of the US federal government
have to follow with respect to regulated entities or persons? Would there be fewer
restatements if there was not such fraternization?

Let me now turn to the kind of problem that we accountants in the Enforcement
Division actually work on. In the year that I have had to look at the problems, I see

228 MARK TO MARKET ACCOUNTING

that we do not deal much with esoteric accounting problems such as foreign
currency translation or the ins and outs of pension accounting or post-retirement
benefits other than pensions. We deal with more pedestrian issues. For example, on
the auditor independence issue, we have one case where the outside auditors of a
company wanting to raise money went around to their other clients and promoted
the stock of the issuer, passed out the subscriptions for the issuer’s stock, and then
took the checks that their clients wrote for the shares of the issuer’s stock and
delivered the checks to the issuer. The SEC has a rule that says that the external
auditor may not be a broker for his or her client and remain independent. So does
the AICPA.

Another independence case that we have is the one involving KPMG Peat
Marwick, which the commission filed in December 1997 and which has been well
publicized. This case has several moving parts, which I will not recite here. KPMG
has responded by denying the commission’s assertions about its lack of
independence. The matter was heard recently by an administrative law judge. The
judge’s opinion will follow in due course.

We also have other independence cases in the works involving ownership by
audit and tax partners and staff of securities issued by audit clients and ownership of
securities issued by the audit client and held indirectly by a trust where a partner in
the CPA audit firm is also a co-trustee of the trust. These cases are not yet resolved.

Let me move on to some of the accounting issues with which we are dealing. The
Enforcement Division was formed in the 1970s. As I said earlier, over the years, I
have heard every one of the division’s chief accountants give speeches wherein they
described their cases. Well, nothing has changed. Registrants are still doing the same
things.

Premature revenue recognition appears to be the recipe of choice for cooking the
books. Recognizing revenue when an undisclosed right of return exists. Recognizing
consigned inventory as sold inventory. Shipping products to company warehouses
or employees’ homes and recognizing sales revenue. Recognizing revenue in advance
of the customer’s acceptance of the product. Keeping the sales journal open after the
end of the quarter or year but back-dating sales invoices. The following is quoted
from the commission’s AAER 1020, dated 25 March 1998, In re Sensormatic;
Electronics Corporation:

The Commission Order finds, among other things, that from at least the start
of its 1994 fiscal year through July 10 1995, Sensormatic manipulated its
quarterly revenue and earnings in order to reach its budgeted earnings goals
and thereby meet analysts’ quarterly earnings projections. During the relevant
period, Sensormatic consistently met, within one cent, the analysts’ forecasts
of quarterly earnings per share, even for the third quarters which were
Sensormatic’s seasonally weaker quarter.

Sensormatic carried out this fraudulent scheme by improperly recognizing
revenue through several different practices. The conduct, which occurred over
a number of years and involved employees throughout the organization,

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 229

primarily involved recognizing and recording revenue in one quarter from
product shipped in the next quarter. At the end of each quarter Sensormatic
turned back its computer clock that recorded and dated shipments so that
out-of-period shipments, and consequently revenue, would be recorded in the
prior quarter. According to the Order, revenue also was recognized through
the following improper practices: recognizing revenue in one quarter, when
products were shipped to warehouses leased by Sensormatic, instead of in the
next quarter, when the products were shipped to the customers; slow
shipments, whereby revenue was recognized on shipments which were made
during the last days of a quarter but which were not scheduled to arrive at the
customers’ location until well into the next quarter; and recognizing revenue
on goods at the time that they were shipped to customers even though the
customers’ contracts with Sensormatic contained an FOB destination
provision. The amount of out-of-period revenue that Sensormatic recognized
in quarters ranged from $4.6 million to $30.2 million.

Sensormatic’s income statement should have been headed up as follows: “Year
ended June 35, 1994.”

Deferral in the balance sheet of costs that should have been reported in income as
operating expenses. Assigning inflated, often outrageously inflated, dollar values to
exchanges of non-monetary assets, particularly with related parties. Assigning
inflated, often outrageously inflated, dollar values to non-monetary assets
contributed to the corporation in exchange for debt or stock of the corporation.
Not disclosing the existence of related parties and transactions with related parties.
Recognizing officers’ salaries as receivables. Recognizing cash taken from the
corporation by officers as cash in the bank or as a direct reduction of stockholders’
equity instead of as a charge to expense. Including brass bars that look like gold bars
in an inventory of gold.

Bleeding into income, without disclosure, “reserves” established in business
combinations or in so-called restructurings. In several recent cases, the bleeding
turned into a hemorrhage from a severed carotid artery. How I dislike that word
“reserve.” It is terribly misleading, Most non-accountants, including lawyers, judges,
and journalists, think that “reserves” have green money in them. For example, the New
York Times of November 16, in an article by Melody Petersen, says that federal
banking regulators often worry that banks have not set aside enough MONEY to
cover expected loan losses. The Wall Street Journal of November 17, in an article by
Elizabeth MacDonald, also equates “reserves” with MONEY Even the New York
Times and the Wall Street Journal think that reserves are vessels containing money.

I thought that the “reserves” issue had been resolved in 1975, when the FASB
issued its Statement 5 on Accounting for Contingencies, but nowadays general
reserves are like crab grass. They are everywhere. Tax liability cushions. Deferred tax
asset cushions. Inventory reserves. Bad debt reserves. Merger reserves. Restructuring
reserves. They are like dirt. Some companies keep a 55-gallon drum of Miracle-Gro
in the garage, and they irrigate their crab grass general reserve accounts with a

230 MARK TO MARKET ACCOUNTING

garden hose hooked up to the drum. Then along comes the Division of Corporation
Finance, in its reviews of filings by issuers, and squirts Roundup from a spritzer
bottle on issuers’ balance sheets, but the crab grass general reserves keep re-emerging.
And the reserves are being used to manipulate earnings. Need a penny a share to
meet Wall Street’s expectations? Need two pennies? A nickel? A dime? Two bits?
Dip into the chocolate chip cookie jar reserve. The mere existence of reserves is a
chocolate chip cookie jar that management finds hard to resist when the earnings
need a sugar high. Let me read to you from the transcript of a September telephone
call between an issuer/registrant and Wall Street analysts:

Analyst: A couple of questions for you Jack. [Jack is the issuer’s CEO.] One on the
conservative accounting. Actually it surprises me that people have any
doubts about the accounting. All the work we’ve done shows it’s really
conservative. Let me ask you about a couple of aspects of the conservatism.
One, it looks like you’re probably over-reserving for indirect sales and that’s
one aspect of the conservatism. If you want to give any clarity on that, that’s
terrific. And two, it looks like your deferred revenues shot up a lot in the
last quarter so it looks like you were holding back revenue recognition, so if
you want to offer anything on that.

Jack: Well you’re absolutely right on both counts. We’ve been extremely
conservative and that’s how you build little honeypots that you can go to,
because when you make these acquisitions in our business planning, we
always project a sequential decline in the revenue of the acquired company,
and we have to go back to our core businesses to get faster growth to cover
up the potential 10–15 percent decline in revenue. And that’s where you see
the releasing of backlog, and that kind of thing, you can only do that if
you’ve created those acorns out there.

Honeypots! Acorns! We need another pass at “reserves.” We need a Year 2000
version of FASB Statement 5.

How about treasury stock carried as an asset in the balance sheet at market, with
gains on sale of treasury stock credited to income. (I’m not making this up.)
Counting on-hand but consigned inventory as owned inventory. How about
increasing fixed assets and crediting cost of sales. Not booking all of the accounts
payable; just put the invoices from suppliers into a desk drawer. Not writing down
or writing off uncollectible receivables. Booking barter trade credits as if they
represented bona fide US dollars. Such is the grist of our accounting mill. Not very
esoteric stuff. If I draw an analogy with police work, what we see is stolen
automobiles with fingerprints on the door handles, not murders where there are no
clues except for dogs that did not bark.

On the audit side, I have seen several non-audits since I came on board last year.
Auditors accepting, with little or no evidential support, values ascribed to both
monetary and non-monetary assets. Artwork by unknown artists booked as assets at
huge amounts but without any support for the assigned value and no inquiry by the
auditor about independent valuation of the artwork. (One registrant did get an

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 231

opinion about the value of artwork it had acquired from an artist through the
issuance of stock. The registrant asked the artist the value of the artwork and the
artist, without modesty, gave his opinion.) Receivables acquired from collection
agencies for pennies but booked at dollars without any documentation and no
auditor inquiry as to the basis for the value. Auditors not doing substantive audit
work but relying on so-called analytical procedures where the evidence, or lack
thereof, cries out for substantive audit work. In one case, the physical inventory test
counts showed a large shortfall from the inventory amount in the general ledger.
Rather than requiring a complete physical count of the inventory or qualifying the
audit opinion, the auditor relied on so-called “analytical procedures,” which led to
acceptance of an erroneous book amount for the inventory. Auditors not doing cut-
off work for sales and purchases, with the result that sales of the next period are
booked in this period with a corresponding increase in receivables from customers,
and accounts payable for purchases of inventory of this period not booked until
next period with the inventory recognized in the balance sheet, resulting in
understated costs of sales and overstated margins. And we see cases where the
auditors were lied to or were not given all of the documentation that they should
have been given. But sometimes I wonder whether the auditors asked the right
questions.

I realize that what I have talked about today is the dark side of financial
accounting and reporting, the side that is not nice to look at. And that the dark side
is very small in relation to the universe. But when we see a steady stream of
restatements by all manner and kind of registrants, not just microcaps, and when we
see a steady stream of articles in business journals entitled “hocus-pocus earnings,”
“abracadabra accounting,” “pick a number, any number,” we regulators take notice.
Investors also take notice. While the numerical count of enforcement cases is small,
a hundred or so a year, one has to ask how much cyanide will poison a well. Will it
take long before investors bid down the prices of securities in our markets to factor
in the uncertainty arising from possible bad numbers and inadequate disclosures?
Perhaps the bidding-down process is already silently taking place. Will investors stop
drinking from the well called audits by “independent certified public accountants”
and sample the water in other wells. You may say that there are no other comparable
wells. Not so. When investors begin to believe that their interests are not being
protected by external auditors, those investors will find an alternative to protect
their interests, in ways other than an audit by independent certified public
accountants.

Postscript

As material for this book was being assembled in April 2003, I reread this speech,
which I gave in 1998, for the nth time. I wish that I had not implied in this speech,
in the third paragraph, that a failure rate of 0.6 percent was acceptable. (Failure rate
determined as a result of retrospective restatements of financial statements because of
errors and irregularities.) Those who prepare and issue financial statements, and

232 MARK TO MARKET ACCOUNTING

those who audit those financial statements, should strive for a failure rate of zero.
Investors expect a failure rate of zero. If numbers in financial statements were to be
based on market prices as I have advocated, and were those numbers to come from
sources outside the reporting enterprise as I have also advocated, the failure rate would
be zero. There would be no retrospective restatements of financial statements.

THE IMPLICATIONS OF ACCOUNTING PRACTICES FOR AUDITING 233

Part III

Accounting standard setting and regulation

35
Schuetze on accounting standard setting and

regulation
Peter W.Wolnizer

This section comprises eleven speeches and addresses and a letter to Sir Bryan
Carsberg, then Secretary-General of the International Accounting Standards
Committee. The speeches include Walter Schuetze’s distinguished lecture at the
University of Texas (Austin), the R.J.Chambers Memorial Research Lecture at the
University of Sydney, and his testimony before the US Senate Committee on
Banking, Housing, and Urban Affairs hearing on “Accounting and Investor
Protection Issues Raised by Enron and Other Public Companies: Oversight of the
Accounting Profession, Audit Quality and Independence, and Formulation of
Accounting Principles.”

While comprehensive in their scope and extensively illustrated with examples
from regulation and practice, four major themes emerge in these speeches. To set
these themes in the overall context of Schuetze’s work, however, it needs to be
appreciated that the majority were delivered in his capacity as the chief accountant
to the Securities and Exchange Commission (SEC) or as chief accountant of the
Enforcement Division of the SEC. Consequently, those speeches addressed specific
topics of contemporary interest to the particular audiences to whom they were
presented.

1 The harmonization or internationalization of accounting standards is ideal
when companies seek to list their securities in foreign countries, provided those
standards yield financial statements that are as relevant, reliable, and
transparent as those produced under US generally accepted accounting
principles. However, the recent implosion of Enron, WorldCom, and other
corporations in the USA may have caused many outside the USA to question
seriously whether financial statements prepared pursuant to US generally
accepted accounting practices are indeed the best.

2 The function of accounting is to inform financial decision making by investors
and creditors. Consequently, accounting standard setters and corporate
regulators should adopt a “capital markets perspective” in determining the kind
of financial information that should be provided to investors.

3 While applauding the achievements and work of the FASB, investors would be
better served if there was a more simple, relevant, and transparent accounting
whereby assets and liabilities are marked to market; and a more reliable style of
auditing, which required auditors to authenticate financial statements by
recourse to evidence outside the reporting enterprise—to commercial evidence
from the marketplace.

4 In the particular context of a potential intervention by the US Congress on the
matter of accounting for stock options awarded to executives, Schuetze argued
that the setting of accounting standards should remain the distinct
responsibility of the private sector—of the FASB overseen by the SEC— and
that the US Congress should not override or interfere with the accounting
standard-setting process. However, in his testimony before the US Senate
Committee on Banking, Housing, and Urban Affairs in February 2002, he
argued that accounting needs “deep and fundamental reform” and that
Congress should require mark-to-market accounting, the implementation of
which should be the responsibility of the SEC.

The reformist views of Walter Schuetze are brought together comprehensively in “A
memo to national and international accounting and auditing standard setters and
securities regulators,” the title of his address delivered as the R.J.Chambers
Memorial Research Lecture on 27 November 2001. They are in crisp focus in his
testimony before the US Senate Committee on Banking, Housing, and Urban
Affairs hearing on “Accounting and Investor Protection Issues Raised by Enron and
Other Public Companies: Oversight of the Accounting Profession, Audit Quality
and Independence, and Formulation of Accounting Principles” on 26 February
2002. Particular reference to that lecture and testimony is made in the introductory
chapter.

The speeches and addresses

The speeches and addresses in this section were delivered over a decade, from
October 1992 to March 2003. With the exception of the R.J.Chambers Memorial
Research Lecture (2001), his testimony before the US Senate (2002) and his address
to the Southwest Regional Meeting of the American Accounting Association
(2003), these addresses were given when Schuetze was chief accountant to the SEC
or chief accountant of the Enforcement Division of the SEC.

The first speech, titled “The setting of international accounting standards,” was
delivered to the members and observers of the IASC in Chicago on 7 October
1992. Here he responds to several inquiries made of him as to whether he supports
the efforts of the IASC to harmonize or internationalize financial accounting and

236 MARK TO MARKET ACCOUNTING

reporting standards for application by issuers of financial statements around the
world. He responded in the affirmative, believing that investors will benefit. But his
positive answer is conditional: international accounting standards have to be
comparable with US generally accepted accounting practices; otherwise, he predicts,
overseas companies will not be successful in raising capital and trading in US capital
markets.

He explores and analyses the pros and cons of each of three ways in which
regulators such as the SEC can deal with financial reports of foreign companies
when considering their listings of securities. One approach is to require that “the
foreign issuers report financial position, results of operations or income, and cash
flows and related disclosures…as the host country would require of host country
issuers.” An alternative is to “allow net income and shareholders equity to be
reconciled from that which is produced using home-country accounting standards
to that which would have resulted using host-country accounting standards if the
issuer does not prepare its basic financial statements using host-country accounting
standards.” That is the current situation in the USA. A second approach is the
multi-jurisdictional disclosure system whereby “the SEC accepts, for investment-
grade debt offerings and related periodic filings, financial statements of Canadian
issuers based on Canadian accounting standards, and the Canadian Securities
Commissions accept financial statements of US issuers prepared using US
accounting standards.” The third approach, which is followed in many European
and Far Eastern countries, “is to allow foreign issuers to issue and list securities, both
debt and equity, based on financial statements using home-country accounting
standards.”

After examining the advantages and disadvantages of each of these, he explores a
fourth possibility, namely “International financial accounting Esperanto
promulgated by the IASC or something like the IASC.” For such an accounting
Esperanto to succeed and become acceptable to investors and regulators around the
world, “it must result in financial statements that have relevance and reliability, and
obviously transparency, as their foundation. The Esperanto must be supportable in
concept and should be simple and practical to implement. It should be fairly
prescriptive and not allow for too much judgment on the part of issuers so as to
maintain a high degree of reliability.”

With his distinctive insight and incisiveness, he compares two recent IASC
proposals with “the beacons of relevance and reliability”—the exposure draft on
research and development and the exposure draft on financial instrument assets —
and finds that they fail those tests based on the IASC’s definition of an asset as a
“resource controlled by the enterprise.” In the case of research and development, he
notes the IASC’s view that a cost per se is an asset and demonstrates that costs fail
the test of control. In the case of financial instrument assets, he notes that the IASC
proposes that financial instrument assets be recognized based on who has the risks
or rewards inherent in the financial asset rather than on who controls it.

He concludes by saying that the IASC has “a tough and delicate job.” Standard
setters, he says, “must have patience and resolve. Most of all they must have

ACCOUNTING STANDARD SETTING AND REGULATION 237

extraordinarily keen hearing. Standard setters must be able to discern the voice of
the investor—sometimes the small, faint voice of the investor—in the din of voices
of all of the supplicants making entreaties to the standard setter.”

In the second speech, “What is the future of mutual recognition of financial
statements and is comparability really necessary? (Information is king),” delivered to
the Third Congrès Fédération des Experts Comptables in Copenhagen on 10
September 1993, he analyzes the mutual-recognition approach whereby regulators
and investors in the host country adopt as adequate whatever financial statements
and related disclosures are acceptable in the issuer’s home country. The issue, he
believes, turns on the question: “What is the objective of the financial statements
and reports being issued by those companies wishing to offer their securities to
investors?” Recognizing the disparities of financial reporting objectives around the
world, Schuetze comes down firmly on the side of a capital-markets approach, one
that is directed towards informing investment and credit decisions. This has been
the approach in the USA since the establishment of the SEC in 1934: “Our public
companies lay out the facts and let market-place participants decide on how the
facts should affect securities prices and how capital should be allocated.” He
observes that the IASC “has adopted much the same approach” and suggests that
“the capital markets approach is the wave of the future for those companies in
Europe and elsewhere that wish to offer their debt or equity securities in worldwide
markets.” Information is “king and queen,” says Schuetze. “Keeping information
private has a cost. That cost is reflected in reduced securities prices.”

Under the mutual-recognition approach, the regulator in the host country
accepts as adequate the financial disclosures that the issuer makes in its home
country. Schuetze argues that while this approach may be less costly and may, on
the surface, appeal to issuers, it places a great burden on investors:

Under that approach, investors have to learn and become familiar with the
accounting requirements of the country of the issuer. …The aim of regulation
should be to help investors, not burden them. Moreover, the mutual-
recognition approach has another drawback, which I call the lowest common
denominator syndrome. By that I mean that managers of some corporations
may not necessarily act in the best interests of investors by factually and
openly reporting financial information.

He concludes:

I think that issuers of financial statements will resolve the conflict between the
desire to keep information private along with the desire to publish only
homecountry information and the need to get a full price for their securities
in the way that they see is in their best self-interest If the issuers want to
maintain closeness about their business affairs, they will opt for less than
transparent disclosures. If, on the other hand, their current owners demand
that the best price possible be obtained for new issues of securities so that

238 MARK TO MARKET ACCOUNTING

current owners’ values are not diluted, and if current and prospective owners
want full pricing of securities in their portfolios, they will choose transparency,
which is the approach to regulation of securities offering we take in the USA.

In the third speech, “A note about private-sector standard setting,” delivered to the
Fourth Annual Conference on Financial Reporting at the University of California at
Berkeley on 29 October 1993, Schuetze tackles the important question of public
versus private accounting standard-setting arrangements. He is particularly
concerned about private-sector accounting standard setting, and specifically with the
relationship between the SEC and the FASB and the FASB’s standard-setting
process. At the time of this address, the FASB had outstanding a proposal that
would have required that the value of stock options issued to employees be reported
as a cost/expense in the financial statements of companies issuing such options.
Several members of Congress had proposed legislation that, in various ways, would
have set aside any final decision by the FASB to require that accounting.
(Subsequently, in 1994, the FASB dropped its proposal to require companies to
recognize as an expense the value of stock options issued to employees.)

The purpose of the speech was not to take sides on the substantive issue of
whether the value of stock options issued to employees should or should not be
recognized as a compensation expense and, if so, at what value. Rather, Schuetze
was concerned with the standard-setting process. In particular, he argued that the
accounting standard-setting process. which is in the hands of the FASB and over-
seen by the SEC, should not be politicized. Referring to the financial disclosure
objectives of the federal securities laws of the 1930s, and the fact that the SEC,
without abrogating its responsibilities in the area of financial accounting and
reporting, “has looked to the accounting profession for leadership in establishing
and improving accounting standards.” As a result, the USA has “what are widely
recognized as the most comprehensive accounting standards in the world.” Schuetze
goes on to explain, in detail, how the FASB goes about setting accounting
standards.

While critical of the fundamental foundations of modern accounting—the
historical-cost doctrine—Schuetze is highly supportive of the work and
achievements of the SEC and FASB working collaboratively. And it is against the
background of that achievement of private-sector accounting standard setting and
commercial auditing that Schuetze argues strongly against the intervention of
Congress in setting accounting standards. “If the effort to legislate in this area
[accounting for employee stock options] is successful, and Congress indeed sets
aside an eventual FASB decision, where does it stop?” He illustrates his argument by
reference to several examples of accounting in which those with strong vested
interests could, potentially, lobby Congress to the detriment of investors, and
concludes: “I don’t know how long this piece of yarn is, once Congress starts pulling
on it.”

Most persuasively, he sets forth his argument by analogy. “I think that it is quite
appropriate for Congress to decide, after consultation with the medical profession,

ACCOUNTING STANDARD SETTING AND REGULATION 239

that the health of US citizens would be improved if there was less emission of
pollutants from automobiles and to pass a law saying that emissions should be
reduced. But I think that Congress should leave the design of fuel injection systems,
catalytic converters, and exhaust systems to automotive engineers.” Acknowledging
that the “standard-setting process in the United States, although the best in the
world, is not perfect,” and that there is “room for constructive advice from
Congress, the business community, investor groups, and others on how the process
may be improved and strengthened,” Schuetze concludes that “it is best to use the
technical expertise available in the process that currently is in place and has worked
for decades, rather than pre-empting that process through congressional action.”

In “Take me out to the ball game,” a speech delivered to the Eighteenth Annual
AICPA National Conference on Banking on 5 November 1993, Schuetze adopts
baseball jargon to compliment the FASB on some of its recent pronouncements and
willingness to re-examine some prior standards. In so doing, he reinforces his views
about the wisdom of having an independent standard-setting apparatus like the
FASB.

Reflecting on his experience of accounting and auditing standard setting over
thirty years—with the AICPA’s Committee on Accounting Procedures, the
Accounting Principles Board, the Accounting Standards Executive Committee of
the AICPA, and the FASB—Schuetze states: “In this world of standard setting,
things take time, sometimes lots of time, and change tends to come in small chunks.
In terms of singles instead of home runs… I think that FASB Statements 114 [on loan
impairment] and 115 [on debt and equity securities] were line-drive singles, not
bouncers through the infield.” While retaining the fuzzy notion of “probable” for
identifying impairment, Statement 114 recognized the importance of the time value
of money. While still based on management intent, Statement 115 requires
marketable securities to be recognized at market value instead of cost:

The standard on pension funds (Statement 87), aside from its complicated
deferrals, which level the hills and valleys of changes in asset and liability
valuations, is a double… The standard on post-retirement healthcare benefits
(Statement 106), aside from its complicated deferrals and its permissible
drawn-out transition provision, is a bases-clearing double. …Had the
standard on cash flow information (Statement 95) required direct reporting
of operating cash flows, it would have been a home run; as it is, it is a stand-
up triple.

Those successes, “along with others such as FASB Statement 14 on segment and
geographical reporting, Statement 52 on foreign currency translation, and
Statement 94 on consolidation, demonstrate the wisdom of having an independent,
full-time, well-funded Financial Accounting Standards Board.” A further strength of
the FASB system, he notes, is shown by its willingness to re-examine prior
standards, “as was done with foreign currency translation where Statement 52
replaced Statement 8, as was done with income taxes where Statement 109 replaced

240 MARK TO MARKET ACCOUNTING

Statement 96, and as the board is now doing with its re-examination of reporting
disaggregated information, which in effect is another look at segment reporting.”

In the second half of his speech, Schuetze looks at one of the FASB’s unfinished
projects—the financial instruments project—which has been on the board’s agenda
since 1986. Recognizing the enormous size and importance of the project, Schuetze
compliments the board on breaking it down into “manageable bites”: for example,
Statement 105 on disclosure about financial instruments with off-balance-sheet risk
and concentrations of credit risk; Statement 107 on disclosure about fair value of
financial instruments; Statement 114 on the recognition and measurement of loan
impairment; and Statement 115 on accounting for and disclosure of investments in
debt and equity securities. And he acknowledges the work that the FASB is doing on
derivative contracts. He concludes: “Given the disclosures with respect to on-
balance-sheet financial instrument items, investors have the necessary ingredients to
make judgments about a bank’s future earnings and cash flows.” However, he
argues that the information provided to investors about derivatives that are used to
manage a bank’s off-balance-sheet assets and liabilities as an end user “is not nearly
so robust.” Schuetze recommends that banks “should consider giving investors as
much information about the off-balance-sheet items used by banks as end users to
manage on balance-sheet assets and liabilities as banks give for the on-balance-sheet
items.” He elaborates in some detail what information he would like to see disclosed
to investors.

The fifth speech, “Financial accounting and reporting in our worldwide
economy” was delivered in the Distinguished Lecture Series at the University of
Texas at Austin on 12 November 1993. There are two parts to the speech. In the
first part, he describes in some detail the function, workings, and structure of the
SEC—the laws it administers, the composition of the commission, and the work
undertaken by its various divisions (Enforcement, Corporation Finance, Market
Regulation, and Investment Management) and offices (of the General Counsel,
Chief Accountant, International Affairs, Economic Analysis, Administrative Law
Judges, Secretary, and Inspector General).

In the second part of the speech, he discusses the function of accounting standard
setting in the context of the role of financial accounting and reporting in US capital
markets. He goes on to trace the history and development of accounting standards
from 1938, when the SEC stated that financial statements that were not prepared in
accordance with principles having “substantial authoritative support” would be
presumed to be misleading. The accounting profession quickly moved to establish
principles that had such authoritative support: the fifty-one Accounting Research
Bulletins issued by the AICPA Committee on Accounting Procedures (1939–59),
“some of which, in one form or another, are still applicable today”; the thirty-one
opinions issued by the APB (1959–73), “many of which survive today in one form
or another”; and the 117 Statements on Financial Accounting Standards and sixty
interpretations and technical bulletins issued by the FASB since its inception in
1973 to the date of his speech.

ACCOUNTING STANDARD SETTING AND REGULATION 241

In his strong advocacy of the capital-markets approach to accounting standard
setting, he argues that “One of the reasons for this country’s deep and highly liquid
financial markets is relevant, reliable, transparent, and credible financial statements.
We have over fifty million individual investors in this country and many thousands
of institutional investors, ranging from the likes of the trust department of the local
bank to the huge pension funds,” all of whom “use financial statements issued by
public companies to make investment decisions, and those investors are able to rely
on those financial statements.” He also argues that financial statements issued by
public companies in Canada, Great Britain, Australia and New Zealand, while
“fairly transparent,” “are not comparable with those issued by companies in the
USA.”

In “An SEC accounting update,” delivered to the AICPA’s Nineteenth Annual
Conference on Banking in Washington on 4 November 1994, Schuetze addresses
three topical subjects: disclosures about derivatives; accounting for derivatives; and
internal audit outsourcing by banks. He compliments the FASB on Statement 119
for requiring disclosures about the nature, terms, and financial-statement effects of
derivatives. However, he suggests “that disclosures about derivatives and cash
positions be supplemented with information that brings the entire risk management
function together so that investors can understand better how the company
manages its overall financial risks.” In particular, he “would like to encourage
registrants to concentrate on quantitative disclosures about market risks inherent in
on- and off-balance-sheet financial instruments and to discuss how these risks are
managed.”

One of the quantitative measures used by companies in their internal risk
management systems is “value at risk”—a measure recommended by the Group of
10 and the Group of 30 and endorsed by the Financial Executives Institute. “Value
at risk is a measure of the potential loss resulting from hypothetical changes in
market factors, such as interest rates and foreign currency exchange rates, for a given
time period. It is used to measure the potential changes in the fair values of financial
instruments arising from changes in market prices or yields.” Schuetze provides an
example of what a “value at risk” disclosure might look like.

He indicated that the SEC’s Division of Corporation Finance had formed a task
force that was then reviewing derivative disclosures by approximately 100 banking
registrants and 400 non-banking registrants. The particular interests of the task
force were to “(1) learn why and how companies are using derivatives, (2)
understand better the current types of disclosures about derivatives, (3) improve
disclosures about derivatives, and (4) form a basis from which the commission could
develop guidance regarding disclosures about derivatives.”

He concludes the speech by addressing the increasing trend by banks and other
financial institutions to outsource their internal audit work, in addition to other
functions such as legal work, data processing, mutual fund back-office work, and
property management. In particular, he cautioned banks not to outsource their
internal audit work to the external auditor as that may compromise that auditor’s
professional independence.

242 MARK TO MARKET ACCOUNTING

The seventh speech in this section, “A review of the FASB’s accomplishments
since its inception in 1973,” was delivered at the AICPAs Twenty-second National
Conference on Current SEC Developments in Washington on 10 January 1995.
The timing of this speech is important: Schuetze had announced his retirement as
chief accountant of the SEC, his final day being 31 March 1995. (He returned to the
SEC in November 1997 as chief accountant to the Enforcement Division.) This is
important for at that time, Walter Schuetze— being the forthright advocate for
accounting reform that he is—had no institutional or professional reason to praise
the work of the FASB. Yet he did. That is the measure of the integrity and
professionalism of the man. His opening remarks on that occasion were: “I have on
occasion been critical about certain financial accounting and reporting issues.
Today, I want to mention some of the positive things in financial accounting and
reporting.”

In this speech, he quotes Sir David Tweedie, his former partner at KPMG and
standard setter: “There’s only three things wrong with accounting—the balance
sheet, the income statement, and the cash flow statement.” Says Schuetze: “That
was about five years ago, and I am pleased to report that Sir David’s Accounting
Standards Board is making good headway in improving accounting in the UK. I am
pleased to say that the FASB is also making good headway in improving accounting
here in the United States.” In his speech, he goes on to say that, in his opinion, the
FASB has been “very good for investors.”

The eighth speech, addressing current developments at the SEC, was delivered at
the Seventeenth Annual SEC and Financial Reporting Institute Conference at the
Leventhal School of Accounting in the University of South California on 14 May
1998. He brought the audience the “good news” that, having regard to the number
of registrants, relatively few open cases were being investigated by the division:
“Although the issues that we deal with in the Enforcement Division are messy and
quite distasteful, they are a very small fraction of the universe.” He made the same
observation in “Good news, bad news, Brillo pads, Miracle-Gro, and Roundup,”
reproduced in the previous section. He arrived at the same conclusion in that
speech, on the following basis: “Our statistics show that the commission completed
about 100 accounting cases a year. If I divide 100 cases by 16,000 commercial and
industrial public companies who file documents with the commission, the result is
about 0.6 percent.” This he attributes to the effectiveness of the Enforcement
Division in overseeing and monitoring the financial reporting practices of
registrants and the severity of penalties that may be imposed for infractions.

Matters that come before the division are seldom “esoteric accounting problems
such as foreign currency translation or the ins and outs of pension accounting or
post-retirement benefits other than pensions.” The most recurrent problems are
“pedestrian” matters such as those described in the section on the “Implications of
accounting practices for auditing.”

On the auditing side, he notes that the Enforcement Division often investigates
matters pertaining to auditor independence. Indeed, he states, “I have now seen
several non-audits.” Under that caption, he includes many of the scenarios described

ACCOUNTING STANDARD SETTING AND REGULATION 243

in the section on the “Implications of accounting practices for auditing.” Referring
to some cases where “the auditors were lied to or were not given all of the
documentation that they should have been given,” he observes that “sometimes I
wonder whether the auditors asked the right questions.”

The speech concludes with an observation about the “fraternization between
auditors and their clients” and an exhortation to auditors to be diligent and prudent
in relation to their professional independence.

In a postscript added to “Good news, bad news, Brillo pads, Miracle-Gro, and
Roundup” for this volume, written after he delivered the following address to the
Southwest Regional Meeting of the American Accounting Association on 7 March
2003, he said “I wish that I had not implied in this speech that a failure rate of 0.6
percent was acceptable. Investors expect a failure rate of zero.” He relates failure rate
“to the result of retrospective restatements of financial statements because of errors
and irregularities.” He suggests that under mark-to-market accounting the failure
rate would be zero.

In his address titled “Watching a game of three-card monte on Times Square” to
the Southwest Regional Meeting of the American Accounting Association on 7
March 2003, Schuetze examines the notion of serviceability— “fitness for intended
use”—of financial statements. He does so by using commonly understood
analogies:

Consumers here in the USA, and around the world as well, are used to the
“serviceability” of the things that they buy and use every day. For example, we
buy Hershey’s candies and Kellogg’s corn flakes and know they are fit to eat.
We fly around the world in Boeing and Airbus airplanes and know that the
planes are safe. We buy IBM and Dell desktop and laptop computers that run
on Microsoft software and are delighted with their performance. Caterpillar
tractors that we take to construction job sites, John Deere combines that we
take into the wheat fields, and Honda automobiles that we drive home from
the showroom perform flawlessly. We buy a GE toaster at the department
store, knowing that the toaster will not give us a shock when we plug it into
the electricity socket at home. We know these products are “fit for their
intended use.” Not so for financial reports.

Referring to the Huron Consulting Group Report, dated January 2003, which
found 330 retrospective restatements of financial statements in 2002, Schuetze
observes that “Assuming 15,000 public company registrants, that is a failure rate of
about 2 percent.” Against the view that such a failure rate might be considered
acceptable, he asks the following question: “Suppose Airbus and Boeing had a
failure rate of 2 percent, or 1 percent, or 0.5 percent, or even 0.1 percent. Would
any of us fly in their airplanes? No! Suppose Hershey or Kellogg had that kind of
failure rate. Would any of us eat the candy or the cereal? No!”

He then considers whether the Sarbanes-Oxley Act of 2002, which he calls “the
mother of all securities laws,” is likely to reduce the failure rates in corporate

244 MARK TO MARKET ACCOUNTING

financial reporting. After examining the three requirements of Section 302(a)
pertaining to the SEC-required certifications of the quality of financial statements
by CEOs and CFOs, Schuetze concludes that the Sarbanes-Oxley Act “is of no
help,” because it “does not touch the real issues, which are accounting issues.” For
this reason, it will not stop earnings management and its by-products: unheralded
corporate failure and the retrospective restatements of financial statements. It is an
incomplete solution to the problem of Enronitis. A complete solution to the
corporate governance dilemmas illustrated by the Enrons and WorldComs
mandates fundamental accounting and auditing reform. Schuetze goes on to
examine the accounting profession’s agenda of “principles-based standards and
standards that refer to the substance of transactions.” He demonstrates how that
approach also will not work and concludes that the vital solution lies in the
formulation of mark-to-market accounting, which he has described as “true north.”
While he does not claim that true north would solve all of the problems in financial
reporting, he argues that “at least we would be working toward getting relevant
numbers. Numbers that are real and have their foundation in the marketplace.”

The address concludes with the identification of the following six benefits
associated with the implementation of mark-to-market accounting:

1 Financial reports would be understandable to retail and institutional investors,
Congress, and the public at large.

2 Financial reports would have increased usefulness in making investment,
lending, corporate governance, and public policy decisions.

3 We would do away with today’s mountain of accounting rules that nobody
understands.

4 We could do away with the FASB and the IASB.
5 We could do away with the 150-hour education requirement for CPAs—no

mountain of rules to memorize.
6 And, finally, continuing professional education requirements for CPAs could

be scrapped.

The implementation of mark-to-market accounting would also solve the
independence problem in auditing and transform auditing into the rigorous
safeguard of the quality of financial statement information that the corporations and
securities laws intended it to be.

The letter

The letter of 12 August 1997 to Sir Bryan Carsberg, then Secretary-General to the
IASC, addressed matters of due process in the deliberations and reporting of the
IASC. In particular, Schuetze urged the IASC to enhance the transparency of its
operations and reporting. He recommended that “future exposure drafts of standards
and final standards include (1) the reason for issuing the standard, (2) a basis for
conclusions setting forth why the proposed standard or final standard requires what

ACCOUNTING STANDARD SETTING AND REGULATION 245

it does and why any dissenters’ reasons are insufficient or incorrect, (3)
identification of the dissenters and the reasons for their dissent, (4) a brief
explanation of other plausible approaches that could have been taken in the
proposed standard or final standard even if none of those approaches is supported
by a dissenter and why the IASC board believes such approaches would be
insufficient or incorrect, and (5) the reasons for changes in the final standard from
the exposure draft.”

After acknowledging the importance of the IASC as a successful standard-setting
body, Schuetze concludes that “The IASC needs to help to guarantee its own
success by issuing standards that, first, produce relevant and reliable information for
use by investors and, second, stand on their own feet by reason of persuasion by the
IASC board in the published basis for conclusions.”

Sir Bryan Carsberg responded indicating general agreement with the
recommendations. They are recommendations that might, with good effect, be
adopted by Sir David Tweedie and his colleagues on the recently established
successor to the IASC, the International Accounting Standards Board.

246 MARK TO MARKET ACCOUNTING

36
The setting of international accounting

standards
Remarks to the International Accounting Standards Committee,

Chicago, 7 October 1992

Your chairman, Arthur Wyatt, graciously asked me to come here today to discuss
with you the setting of international accounting standards from the perspective of
the new chief accountant of the USA’s Securities and Exchange Commission. I thank
him and you for this opportunity and this platform.

Since I took up my new post in January of this year, I have been asked several times
whether I support efforts by your committee, the International Accounting
Standards Committee, to “harmonize” or “internationalize” financial accounting
and reporting standards for application by issuers of financial statements around the
world. The short answer to that question is “yes.” I say yes because I think that
investors around the world will benefit therefrom.

Let me explore with you, conceptually and philosophically, the choices that
regulators around the world have as they address the question of differing or
different accounting standards in different countries. One approach as to what
regulators could do is what we in the USA have done. That is, the regulator of the
host country, faced with filings by foreign issuers, could require the foreign issuers
to report financial position, results of operations or income, and cash flows and
related disclosures such as related party transactions, loss contingencies, segments,
asset pledges, and the like, as the host country would require of host-country issuers.
Alternatively, the regulator could, as we also do in the USA, allow net income and
shareholders’ equity to be reconciled from that which is produced using home-
country accounting standards to that which would have resulted using host-country
accounting standards if the issuer does not prepare its basic financial statements
using host-country accounting standards. In the USA, we have 481 SEC registrants
who either follow US generally accepted accounting practices in preparing their
basic financial statements or reconcile.

The host-country presentation and reconciliation approach has the advantage of
presenting information in a way that is familiar to investors in the host country.
Those investors are used to seeing things dealt with in a particular way in the

financial statements, and they are comforted by this approach. Those investors can
compare a foreign issuer’s financial statements with those of issuers in the host
country. It has the drawback of requiring the issuer to incur the cost, at a
minimum, of developing information necessary to provide disclosures that are
incremental to those required in the home country and, at the extreme, to keep two
sets of records. It also requires the issuer’s auditors and other financial advisers to
become knowledgeable in the accounting standards and disclosure requirements of
the host country. Another drawback is that the issuer must follow standards in
which it had no say and to which it may object as a matter of principle or on other
grounds, such as the cost of gathering information.

A second approach would be along the lines that the USA’s Securities and
Exchange Commission and Canada’s Securities Commissions agreed to several years
ago, the so-called multi-jurisdictional disclosure system. Under this system, the SEC
accepts, for investment-grade debt offerings and related periodic filings, financial
statements of Canadian issuers based on Canadian accounting standards, and
Canadian Securities Commissions accept financial statements of US issuers prepared
using US accounting standards. That approach has the benefit of not requiring
issuers to spend the money to keep two sets of records and employ accounting and
auditing experts who are knowledgeable in both countries’ financial accounting and
reporting standards. That approach has the drawback that it requires investors in
both countries to learn the accounting standards in both countries and keep up to
date with changes in those standards. Of course, in the case of Canada and the
USA, the accounting standards and disclosure requirements are fairly close together,
and the SEC found, after lengthy study, that the Canadian requirements satisfied
the requirements of our securities laws.

Another approach is that which I understand is followed in many European
countries, and in many Far Eastern countries, which is to allow foreign issuers to
issue and list securities, both debt and equity, based on financial statements using
home-country accounting standards. This approach allows for the greatest possible
flexibility on the part of an issuer and correspondingly imposes the greatest burden
on investors and creditors, for they have to learn and keep current with changing
accounting standards around the world. This latter approach seems to me to be the
least efficient way possible. It just does not seem possible, even given the
communications technology currently available, for investors in all the countries to
be able to understand all the ins and outs and nuances of the accounting standards
and the way or multiple ways in which those standards are applied in practice in the
various countries. A US investor, for example, is unlikely to understand fully how
and why companies in other countries, even those geographically close by, apply
accounting standards the way they do. The accounting standards and disclosure
practices of a country derive from commercial business practices in that country, the
civil law in that country, contract law in that country, tax law in that country, and
custom in that country. It seems to me that it is asking a lot of investors in a
country to know and understand what underlies other countries’ accounting
standards and disclosure practices or requirements. Although many assert that the

248 MARK TO MARKET ACCOUNTING

price of an issuer’s securities is set by investors in the issuer’s home country, it seems
to me, intuitively, that an issuer’s securities will not be priced efficiently around the
world if investors around the world do not fully understand the issuer’s financial
statements.

That then leads to the fourth possibility, namely international financial
accounting Esperanto promulgated by the IASC or something like the IASC. I think
that, in the long run, agreement on such an accounting Esperanto holds out the
most promise for international investors and creditors and perhaps for international
issuers as well.

In order for such an accounting Esperanto to succeed and become acceptable to
regulators around the world, and indeed to investors and creditors around the world,
it seems to me that it must result in financial statements that have relevance and
reliability, and obviously transparency, as their foundation. The Esperanto must be
supportable in concept, and it should be simple and practical to implement. It
should be fairly prescriptive and not allow for too much judgment on the part of
issuers so as to maintain a high degree of reliability. If those qualitative
characteristics of the information produced by the accounting Esperanto are
present, then it seems to me that regulators such as the USA’s Securities and
Exchange Commission will be favorably disposed to its acceptance. That will be
because investors and creditors will be both protected by and benefit from financial
accounting information having such qualities. We have fifty-one million individual
investors in the USA. Our commission will have to be satisfied that those investors
are protected and will benefit before it will be inclined to allow international
accounting Esperanto to replace US generally accepted accounting principles in the
preparation of financial statements disseminated to our public.

Let me take two of your recent proposals and compare them with the beacons of
relevance and reliability.

In your conceptual framework, you define an asset as a “resource controlled by
the enterprise.” Yet, in your proposal on research and development, you have
tentatively concluded that a cost per se is a resource, in that development cost may
qualify for recognition as an asset if certain conditions are met To me, a resource, or
an asset, in order to be controlled, is something that can be identified and sold, or
pledged to a bank as collateral for a loan. A cost as such cannot be sold, or pledged
to secure a loan. A cost cannot be controlled. Furthermore, the conditions for cost
capitalization are quite judgmental and will be very difficult to verify. Indeed, it
appears that the conditions are so judgmental that capitalization may be optional.
So it seems to me that that proposal does not measure up on the counts of relevance
or reliability. However, I might note that what you are proposing for development
cost is not unlike what the Financial Accounting Standards Board did with respect
to software costs in FASB Statement 86.

In your financial instruments exposure draft, you would have financial
instrument assets initially recognized and subsequently de-recognized based not on
who controls the financial instrument but on who has the risks or rewards inherent
in the financial instrument. Using risks or rewards as the criterion for recognition

ACCOUNTING STANDARD SETTING AND REGULATION 249

and de-recognition instead of control will result in the reporting of phantom assets,
phantom liabilities, phantom revenue, and phantom expense. That criterion will
also result in written credit puts not being recognized as liabilities at fair value by
transferors and not reducing shareholders’ equity by the amount of that fair value.
Commercial banks and thrift banks in the USA have sold upward of $1.5 trillion of
receivables with recourse. Under the criterion of risk, those banks would have to
reinstate the unpaid/uncollected portion of those receivables, along with an equal
liability, to their balance sheets, whereas, under the notion of control, those receivables
are not on the face of the balance sheets. I do not think it is relevant to balloon
banks’ balance sheets with receivables that they do not own and do not control.

Moreover, under the exposure draft on financial instruments, management intent
plays an important role in the accounting. We have seen in the USA that relying on
management intent with regard to marketable securities does not produce reliable
financial statements; management intent cannot be verified.

Finally, that exposure draft would continue to favor historical cost for long-term
investments in marketable securities as opposed to market value.

My assessment is that the exposure draft would not meet the twin tests of
relevance and reliability. But I would have approximately the same comment about
the FASB’s recent exposure draft on debt and equity securities, which relies on
management intent and, to some extent, on historical cost for marketable securities.

That said, however, I am hopeful that the IASC can, in the future, promulgate
standards that meet the twin tests of relevance and reliability along with the
companion tests of simplicity and practicality If that happens, it may force national
standards to converge along the lines of international standards. And that convergence
would be good. I can even see the day where we at the commission would conclude
that a foreign issuer would not necessarily have to follow every jot and tittle of one
of our very complex US accounting standards if compliance with international
accounting Esperanto produced financial statements that both protected and
benefited fifty-one million US investors.

Let me close by saying that you have a tough and delicate job. Standard setters
must have patience and resolve. Most of all they must have extraordinarily keen
hearing. Standard setters must be able to discern the voice of the investor—sometimes
the small, faint voice of the investor—in the din of voices of all of the supplicants
making entreaties to the standard setter.

250 MARK TO MARKET ACCOUNTING

37
What is the future of mutual recognition of

financial statements, and is comparability really
necessary?

Information is king

Remarks to Third Congrès Fédération des Experts Comptables,

Copenhagen, 10 September 1993

The main heading for today’s panel discussion is “What is the future of mutual
recognition of financial statements, and is comparability [of financial information]
really necessary?”

The detailed subheading for the discussion is: “Can changes be expected to the
accounting, presentation, and disclosure requirements imposed by capital market
regulators in foreign companies wishing to raise finance in their jurisdic tions?
Should comparability be a necessary precondition for the mutual recognition of
financial statements? How can the role of the IASC enhance and influence these
issues? Should not current practices in Europe be accepted by regulators elsewhere?”

In accordance with the commission’s policy, I must tell you that my answers to
these questions and my other remarks today will be my views, and will not
necessarily reflect the views of the commission or my colleagues on the
commission’s staff.

The answers to those questions, to me, depend on how one answers an unasked
question, namely, what is the objective of the financial statements and reports being
issued by those companies wishing to offer their securities to investors? Is the
objective to make decisions about income to be reported to taxing authorities? Is the
objective for state planners outside the enterprise to make decisions about tax
policy, labor policy, or other state matters? Is the objective to determine the amount
of cash that may safely be distributed to owners of the business while maintaining
sufficient resources within the enterprise to provide jobs for the present workforce
and possibly additional workers? Is the objective to state net assets and income with
a downward bias so as to minimize demands by owners for dividends? Or is the
objective one that is oriented primarily toward the capital markets, that is, toward
investors and creditors and making investment and credit decisions?

In the United States of America, starting in the 1930s after the Great Depression
and then after World War II, we embarked on a course of preparing financial
statements for use by those who make investment decisions. The American Institute

of Certified Public Accountants’ Committee on Accounting Procedures, in the
introduction to Accounting Research Bulletin No. 43, Restatement and Revision of
Accounting Research Bulletins, wrote as follows in the early 1950s:

In the past fifty years there has been an increasing use of the corporate system
for the purpose of converting into readily transferable form the ownership of
large, complex, and more or less permanent business enterprises. …As a result
of this development, the problems in the field of accounting have increasingly
come to be considered from the standpoint of the buyer or seller of an interest
in an enterprise, with consequent increased recognition of the significance of
the income statement. …The fairest possible presentation of periodic net
income, with neither material over-statement nor understatement, is
important, since the results of operations are significant not only to
prospective buyers of an interest in the enterprise but also to prospective
sellers.

Writing in 1978, the Financial Accounting Standards Board, in its Concepts
Statement 1, said:

the objectives in this Statement are focused on information for investment
and credit decisions [for those] who generally lack the authority to prescribe
the information they want…[paragraph 30].

The objectives are those of financial reporting rather than goals for
investors, creditors, or others who use the information or goals for the
economy or society as a whole. The role of financial reporting in the economy
is to provide information that is useful in making business and economic
decisions, not to determine what those decisions should be. For example,
saving and investing in productive resources (capital formation) are generally
considered to be prerequisite to increasing the standard of living in an
economy. To the extent that financial reporting provides information that
helps identify relatively efficient and inefficient users of resources, aids in
assessing relative returns and risks of investment opportunities, or otherwise
assists in promoting efficient functioning of capital and other markets, it
helps to create a favorable environment for capital formation decisions.
However, investors, creditors, and others make those decisions, and it is not a
function of financial reporting to try to determine or influence the outcomes
of those decisions. The role of financial reporting requires it to provide
evenhanded, neutral, unbiased information. Thus, for example, information
that indicates that a relatively inefficient user of resources is efficient or
investing in a particular enterprise involves less risk than it does and
information that is directed toward a particular goal, such as encouraging the
reallocation of resources in favor of a particular segment of the economy, are
likely to fail to serve the broader objectives that financial reporting is intended
to serve [paragraph 33].

252 MARK TO MARKET ACCOUNTING

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 [paragraph 34].

Financial reporting should provide information to help present and
potential investors and creditors and other users in assessing the amounts,
timing, and uncertainty of prospective cash receipts from dividends or interest
and the proceeds from the sale, redemption, or maturity of securities or loans
[paragraph 37].

In fulfilling that capital-markets objective, financial accounting and reporting in the
United States of America has developed into a system where public companies
present the facts surrounding their businesses and operations with great
transparency. The degree of the transparency is bounded or constrained only by the
necessity to summarize information so as to get the information into a report of
manageable size that may be sent to owners and creditors and may be understood
and digested and used by them. In this system, information is king, and also queen.
Our public companies lay out the facts and let marketplace participants decide on
how the facts should affect securities prices and how capital should be allocated.

The International Accounting Standards Committee, in its Framework for the
Preparation and Presentation of Financial Statements, has adopted much the same
approach to deciding what should go into financial statements, that is, an investor-
oriented, capital-markets approach. In paragraph 10 of its framework, the IASC
said, “as investors are providers of risk capital to the enterprise, the provision of
financial statements that meet their needs will also meet most of the needs of other
users (such as, employees, lenders, trade creditors, customers, governments, and the
public) that financial statements can satisfy.” The IASC, in its framework, also lists
most of the same qualitative characteristics of financial information as does the
FASB: for example, relevance, reliability, neutrality, and comparability.

I think that the capital-markets approach is the wave of the future for those
companies in Europe and elsewhere that wish to offer their debt or equity securities
in worldwide markets. If those companies are unwilling to provide to the investing
public the same information that they provide privately to their major debt and
equity holders, then those companies cannot, it seems to me, expect worldwide
investors to bid the full price for their securities. Keeping information private has a
cost. That cost is reflected in reduced securities prices. I have heard and understand
the argument that the price of an issuer’s securities is set in the home-country
market and is accepted by participants in other markets and therefore there is no
need to make any more disclosures than are considered necessary by the home-
country regulator. But that argument ignores the fact that an issuer’s securities may
not be fully priced by participants in the home-country marketplace if disclosures in
that marketplace are opaque. It also seems to me, intuitively, that if worldwide
investors have a choice as to whether to buy the securities of two issuers—one whose
disclosures are great and transparent and one whose disclosures are minimal and

ACCOUNTING STANDARD SETTING AND REGULATION 253

opaque—the investor will select the securities of the issuer whose disclosures are
great and transparent, all other things being equal.

Under the mutual-recognition approach to regulation of securities offerings, the
regulator in the country where the securities are sought to be offered and listed
would accept as adequate whatever disclosures the issuer makes in its home country.
While this approach may, on the surface, appeal to issuers, it places a great burden
on investors. Under that approach, investors have to learn and become familiar with
the accounting requirements of the country of the issuer. That approach burdens
rather than helps investors. I do not see as practical the proposal that investors in
another country know enough about the disclosure requirements and accounting
rules or practices in the issuer’s country so as to make informed decisions about
prices of the issuer’s securities. The aim of regulation should be to help investors, not
burden them.

Moreover, the mutual-recognition approach has another drawback, which I call
the lowest common denominator syndrome. By that I mean that managers of some
corporations may not necessarily act in the best interests of investors by factually
and openly reporting financial information. If some companies in worldwide
markets smooth their earnings, or indeed determine the amounts of their earnings,
on an undisclosed and discretionary basis through the use of hidden accounting
reserves, other companies may be motivated to report in a similar way so as to
preserve perceived competitive advantage. If some companies, selectively and
without disclosure of relevant details, omit cash, working capital, plant, and debt
from their financial statements by not consolidating the financial statements of
subsidiaries, or some subsidiaries, other companies may be motivated to report in a
similar way. If some companies, on the acquisition of other companies, recognize
liabilities or asset-valuation allowances that have no basis in fact, so as to allow the
release of those amounts into earnings in periods after the acquisition, other
companies may want to do likewise. If this syndrome became widespread, financial
accounting and reporting could sink to a very low level. Although this condition
probably would not persist over the long term, I think that any movement of this sort
would harm investors.

There is a large body of academic research and literature that says that the
accounting numbers that are disclosed by reporting companies can affect stock prices.
That accounting numbers make a difference. That accounting numbers are
important. I think that issuers of financial statements will resolve the conflict
between the desire to keep information private along with the desire to publish only
home-country information and the need to get a full price for their securities in the
way that they see is in their best self-interest. If the issuers want to maintain
closeness about their business affairs, they will opt for less than transparent
disclosures. If, on the other hand, their current owners demand that the best price
possible be obtained for new issues of securities so that current owners’ values are not
diluted, and if current and prospective owners want full pricing of securities in their
portfolios, they will choose transparency, which is the approach to regulation of
securities offerings we take in the USA.

254 MARK TO MARKET ACCOUNTING

In closing, I would like to share with you some statistics that I believe
demonstrate the success of complete and transparent financial reporting systems,
such as the system used in the United States. Last year alone, equity trading volume
in the USA grew by 18 percent to nearly (US)$3 trillion. The growth of securities
registered for public offering in the USA was also exceptional, increasing more than
37 percent in 1992 to $610.5 billion. Registered initial public offerings for debt and
equity rose by nearly 43 percent to about $52 billion. More significant to this
audience, securities registered for public offering in the United States by foreign
issuers grew 32 percent from $25 billion to $33 billion between 1991 and 1992. In
the first seven months of 1993, foreign company registrations reached $26.5 billion.
Since 1 January 1990, 228 companies from thirty-one countries have entered the
US public securities markets for the first time. Over that period, foreign issuers
registered approximately $94 billion of securities for issuance to the public. Today, a
total of thirty-nine countries, including all major markets except Germany, are
represented among the 557 foreign issuers having securities registered with the
commission. And earlier this year, Daimler Benz announced that it will be the first
German company to list its shares on the New York Stock Exchange.

I believe that it is, in large part, the SEC’s commitment to a financial reporting
system with the objective of providing full disclosure to investors that has made the
US securities markets attractive for global as well as domestic capital formation.
Such transparency must, in my personal view, be a primary ingredient in any
standards that are to receive worldwide recognition.

I would like to thank the federation for inviting me to participate in today’s panel
discussion, and I look forward to hearing the other participants’ views.

ACCOUNTING STANDARD SETTING AND REGULATION 255

38
A note about private-sector standard setting

Remarks to Fourth Annual Conference on Financial Reporting, Haas

School of Business, University of California at Berkeley, San

Francisco, 29 October 1993

Thank you very much for inviting me to be the luncheon speaker at this fourth
annual conference on financial reporting. Let me say at the outset that my remarks
represent my views and mine alone and that I do not speak for the commission or
other members of the staff.

I want to speak today about private-sector standard setting and specifically the
relationship of the commission to the Financial Accounting Standards Board and
the FASB’s standard-setting process. The occasion for these remarks is that
Congress is considering whether it should intervene in the standard-setting process
because the FASB’s tentative conclusions, if ultimately adopted, would result in the
value of stock options issued to employees being reported as a compensation cost/
expense in companies’ financial statements.

On the one hand, Senator Levin and Representative Bryant have been concerned
that the use of stock options to compensate high-level management employees has
resulted in hundred million dollar pay days for certain CEOs, which are never
reflected in their companies’ financial statements. On the other hand,
Representative Eshoo and Senator Bradley have introduced “sense of the House”
and “sense of the Senate” resolutions objecting to the FASB’s tentative conclusion,
and Senator Lieberman et al. have introduced a bill that would set aside any decision
that the FASB may reach. Senator Lieberman’s bill would preclude the recognition
of the value of employee stock options as an expense, as a matter of law. Those who
have supported Senator Lieberman’s bill say that a requirement to recognize a cost/
expense for stock options issued to employees would be harmful to business and
would put US businesses at a competitive disadvantage with foreign companies.

However, my purpose today is not to take a side in the substantive debate on
whether the value of stock options issued to employees should or should not be
recognized as a compensation cost/expense and, if so, how that value should be
measured. What I want to do today is talk about the standard-setting process.

As you know, the federal securities laws, enacted in the 1930s, are intended to
protect investors through the disclosure of reliable, material information. Financial
statements, prepared by managements and audited by outside independent
accountants, are a central feature of this disclosure system. Indeed, I think that
financial information—financial information having a high degree of relevance,
reliability, and, most of all, transparency—is the lubricant that allows the engine of
our system here in the United States to run at a very high rate of RPMs. To be sure,
products have to be manufactured, services have to be available, and products and
services have to be packaged, distributed, and sold for businesses to be successful,
and no amount of financial maneuvring or engineering will be able to turn poor or
substandard products or services into successes. Similarly, no amount of financial
reporting should turn a good product or quality services into business failures.
However, the way we recognize, measure, and report these business activities to
investors and potential investors is crucial to the turning of the wheels of commerce
and business.

Since 1938, the commission, without abdicating its responsibilities in this area,
has looked to the accounting profession for leadership in establishing and improving
accounting standards. Working in partnership, the SEC and the accounting
profession have established what are widely recognized as the most comprehensive
accounting standards in the world. These standards provide for transparency of the
economic conditions, events, and transactions affecting public entities and allow
investors to decide how the underlying facts should affect securities prices and the
allocation of capital. I believe that it is, in large part, the commitment in this
country to an accounting system that has the objective of providing complete and
unbiased financial information to investors that has made the US securities market
attractive to both domestic and global capital formation.

The Financial Accounting Standards Board has been the private-sector body
designated by the accounting profession to set accounting standards since 1973.
The FASB’s concepts statements, which set forth the fundamental precepts that the
FASB uses in setting standards, stress that financial reporting should not be viewed
as an end in itself but as a means to provide information that is useful in making
economic and business decisions. In order to achieve this objective, the FASB listens
to the concerns of all of its constituents and then writes and issues, without bias or
favoritism, standards that are designed to reflect economic conditions, events, and
transactions as objectively as possible. The FASB’s mission statement accents this
approach by stating that the FASB must, among other things: (1) be objective in its
decision making; (2) weigh carefully the views of its constituents; (3) promulgate
standards only when the expected benefits exceed the perceived costs; and (4) bring
about needed changes in ways that minimize disruption to the continuity of
reporting practice.

To implement the concepts statements and mission statement, the meetings of
the FASB concerning proposed standards are open to the public, and prior to acting
on any significant proposed standard, a discussion memorandum or similar initial
document exploring all the issues is published for public comment, public hearings

MARK TO MARKET ACCOUNTING 257

are held, drafts of the proposal are published for public comment, and the proposal
may be field tested. After studying information from all of these sources, the FASB
then re-deliberates the proposal. The commission staff, through the Office of the
Chief Accountant, reviews each standard-setting proceeding carefully by reading
comment letters, observing FASB meetings and public hearings, and expressing its
concerns and interests to the FASB and its staff. Once a standard is adopted, the
SEC staff continues to consult with the FASB staff on implementation issues and
whether interpretations or changes in the standard may be necessary to achieve the
objective of the standard. I strongly endorse this process for setting accounting
standards and believe that it should continue, unabated, in the future.

The success of this process is of vital concern not only to the commission,
investors, and the accounting profession but also to Congress. In my view, it is
certainly appropriate for Congress to question whether this standard-setting process
fulfills the goals of the federal securities laws and to oversee the efforts of public and
private standard-setting bodies in implementing those laws. It is also appropriate for
Congress to be concerned with whether the accounting profession is acting in the
best interests of investors.

However, setting accounting standards is a complex task. Very often, in seeking
to address one question, the FASB and the SEC must be careful that they are not
creating new, tougher questions. And should the neutrality of the process even
temporarily be overshadowed by the interests of one industry or group, or one set of
interests over another, accounting standards may result that make it difficult not
only for investors but also for public policy officials to make informed decisions
based on the facts. Examples may be found on both sides—where actual economic
conditions were shielded from the public’s view and appropriate decision making
was delayed (such as through the use of regulatory accounting principles and the
construct of “net worth certificates” for certain thrifts), and where economic
conditions were portrayed more accurately and fueled what many consider
appropriate and timely public policy debates (such as the recognition and
quantification of post-retirement healthcare costs).

If the effort to legislate in this area is successful, and Congress indeed sets aside an
eventual FASB decision, where does it stop? For example, would those who opposed
timely recognition of costs and liabilities for employee pension benefits and post-
retirement healthcare benefits now want to go to Congress and ask it to overturn
FASB Statements 87 and 106 on pensions and post-retirement benefits? US
manufacturers can say that having to recognize those costs and liabilities on a
timely, accrual basis instead of on the cash basis is incorrect because it decreases
income and equity before cash flows out. That it puts them at a disadvantage with
foreign competitors who are not directly burdened with those costs and liabilities but
pay for such benefits indirectly through income tax regimes on a cash basis.

Would those who have to mark to market certain of their marketable securities
now wish to go to Congress and ask for relief from the requirements of FASB
Statement 115? US commercial banks and insurance companies can say that their
shareholders’ equities are too volatile because of that requirement. That foreign

258 ACCOUNTING STANDARD SETTING AND REGULATION

banks and insurance companies do not have to mark to market their holdings of
certain marketable securities and therefore are at a competitive advantage.

Would those who have to recognize foreign currency transaction gains and losses
currently in income now wish to go to Congress and ask for relief from the
requirements of FASB Statement 52? US companies can say that their incomes and
stockholders’ equities are either under- or overstated because of that requirement.
That foreign companies are allowed to defer such gains and losses and thus have an
advantage over US companies.

Would those who have to charge research and development costs to expense when
incurred now wish to go to Congress and ask for relief from FASB Statement 2? US
companies can say that companies should be able to defer such costs if, in their
judgment, the amounts will be recovered in the future through royalties or sales of
products. That foreign companies may defer such costs and therefore enjoy an
advantage over US companies.

I do not know how long this piece of yarn is, once Congress starts pulling on it.
I do not mean to be disrespectful to those who have asked Congress to step into

this debate on the accounting for stock options issued to employees. Nor do I mean
any disrespect to any members of Congress for entering this debate. I just believe
that Congress is not the forum to determine the specific accounting standards that are
necessary for the protection of investors and that provide for the smooth and
efficient functioning of our capital markets. Let me use an analogy. I think that it is
quite appropriate for Congress to decide, after consultation with the medical
profession, that the health of US citizens would be improved if there were less
emission of pollutants from automobiles and to pass a law saying that emissions
should be reduced. But I think that Congress should leave the design of fuel
injection systems, catalytic converters, and exhaust systems to automotive engineers.

The FASB, with its technical expertise, and the SEC and its staff, are uniquely
positioned to perform the task of setting accounting standards. Based on my
experiences as the chief adviser to the commission on accounting and auditing
issues, as one of the original FASB members, and as a practicing accountant for over
thirty years, this process achieves its best results when the establishment of specific
accounting standards is left to those bodies having technical expertise.

The standard-setting process in the United States, although the best in the world,
is not perfect. There is room for constructive advice from Congress, the business
community, investor groups, and others on how the process may be improved and
strengthened. In designing specific standards, however, in my opinion, it is best to use
the technical expertise available in the process that is currently in place and has
worked for decades rather than pre-empting that process through congressional
action.

MARK TO MARKET ACCOUNTING 259

39
Take me out to the ball game

Remarks to the Eighteenth Annual AICPA National Conference on

Banking, Washington, 5 November 1993

I am pleased to share this session with my former partner, John Shanahan, and with
Denny Beresford, chairman of the FASB. My remarks represent my views and mine
alone, and I do not speak for the commission or other members of the staff.

At the outset, let me commend the FASB for working long, hard hours to issue
Statement 114 on loan impairment and Statement 115 on debt and equity
securities earlier this year. I think that investors are and will be the beneficiaries of
that work, and I applaud the FASB.

I have been working in the auditing and accounting standard-setting business for
a long time. In 1963, when I was at Peat Marwick, I started working with that
firm’s representatives on the AICPAs Committee on Auditing Procedures and the
Accounting Principles Board. Starting in 1966 through 1970, I was one of the
technical advisers to a member of the Accounting Principles Board. From 1973 to
mid-1976, I was one of the original members of the FASB. And, off and on from
1979 through 1991, I was a member of then chairman of the Accounting Standards
Executive Committee of the AICPA. So I think that I know something about this
business.

In the accounting standard-setting business, one has to deal with things emotional
and things psychological as much as with things technical. Standard setting in
accounting is as much about managing change as it is about understanding
technical financial accounting and reporting. Accounting standard setting is the
process of making changes to recognize shifts in business practice and economic
situations and sometimes to reflect changes in accounting thought. Some people,
especially preparers of financial statements, might welcome less change. I have heard
a few of them say that the FASB should take a long holiday. But that is not the way
the world is.

In this world of standard setting, things take time, sometimes lots of time, and
change tends to come in small chunks, in singles instead of home runs. Sometimes
in bunt singles. Sticking with the baseball vernacular, I think that FASB Statements

114 and 115 were line-drive singles, not bouncers through the infield. In Statement
114, while retaining the indefinite standard of “probable” for identifying
impairment in Statement 5, the board recognized the importance of the time value
of money. That required the elimination of part of old Statement 15, which
had allowed, indeed required, that the time value of money be ignored in
accounting for troubled debt restructurings. FASB Statement 115, although still
based on management intent as to debt securities, requires marketable securities to
be recognized at market instead of cost, making the financial statements more
relevant. Based on Statements 114 and 115 and other recent board actions, I think
that the FASB has been doing quite well. The standard on pension benefits
(Statement 87), aside from its complicated deferrals, which level the hills and valleys
of changes in asset and liability valuations, is a double; research studies have shown
that investors are demonstrably taking the pension disclosures and impounding
them into stock prices. The standard on post-retirement healthcare benefits
(Statement 106), aside from its complicated deferrals and its permissible drawn-out
transition provision, is a bases-clearing double. Research also shows that investors
are using information produced by that standard. Indeed, not since line-of-business/
segment reporting was introduced in the 1970s has an accounting standard so
dramatically and forcefully communicated so much information to so many people
as has Statement 106 on post-retirement benefits. Had the standard on cash flow
information (Statement 95) required direct reporting of operating cash flows, it
would have been a home run; as it is, it is a stand-up triple. Investors are more than
cheering spectators when the FASB scores; investors are the very real winners in a
very real game affecting their fortunes.

Those successes by the FASB, along with others such as FASB Statement 14 on
segment and geographical reporting, Statement 52 on foreign currency translation,
and Statement 94 on consolidation, demonstrate the wisdom of having an
independent, full-time, well-funded Financial Accounting Standards Board. They
demonstrate the wisdom of the board’s having a mission statement and concepts
statements that drive toward financial information that is relevant, reliable,
complete, neutral, free from bias, and even-handed—that will produce financial
information that is useful for making economic and business decisions. That will
produce financial information that is transparent and credible.

A further strength of the FASB system is shown by the fact that the FASB is
willing to, and does, re-examine prior standards, as was done with foreign currency
translation, where Statement 52 replaced Statement 8; as was done with income
taxes, where Statement 109 replaced Statement 96; and as the board is now doing with
its re-examination of reporting disaggregated information, which in effect is another
look at segment reporting. This demonstrates the wisdom of having a standard-
setting apparatus that is the finest of its kind—one that works.

That said, let me now turn to one of the FASB’s unfinished projects, namely the
financial instruments project, which is of much interest to this audience. That
project has been on the board’s agenda a long time, since 1986. In fact, the longer
the board works on that project, the more we learn how significant it is and how

MARK TO MARKET ACCOUNTING 261

large it is. To give you some idea of how large I think it is, I think it is larger than a
bread box and larger than my Buick. It’s about as large as the Queen Mary. The
board has broken the project down into manageable bites; we have a standard on
disclosure about financial instruments with off-balance-sheet risk and
concentrations of credit risk (Statement 105), a standard on disclosure about fair
value of financial instruments (Statement 107), a standard for recognition and
measurement of loan impairment (Statement 114), and a standard on accounting for
and disclosure about investments in debt and equity securities (Statement 115). And
now the board is working on what to do about forwards, exchange-traded futures,
options, and swaps, or generally speaking, the so-called derivative contracts, of
which there are now hundreds.

As things stand now, investors know a lot about what appears on a bank’s balance
sheet and what went on during the year about cash financial instruments that are
recognized on a bank’s balance sheet. Taking a bond, for example, the investor can
see the bond’s cost, its maturity date and amount, and its market value. The coupon
interest rate may not be disclosed explicitly but may be inferred. The investor sees
the interest income recognized on the bond in the income statement. And if there were
sales and purchases of bonds, the investor sees cash receipts coming in and cash
payments going out in the cash flow statement. With respect to liabilities like
deposits and debentures, investors can see the maturity amount, the fair value, and
maturity dates. Coupon rates, if not explicitly disclosed, may be inferred. The
income statement shows an amount representing interest expense, and the cash flow
statement shows activity in issuances and extinguishments of debentures payable.

Given the disclosures with respect to on-balance-sheet financial instrument items,
investors have the necessary ingredients to make judgments about a bank’s future
earnings and cash flows. The investor can make his or her own judgment about the
course of interest rates in the future, how quickly the bank can react to changes in
interest rates, the prospects of bad debts in the bank’s customer base, the bank’s cost
structure, competition, regulatory changes, and the like, and come up with some
fairly good ideas about a bank’s future income and cash flow streams.

The information given to investors about derivatives that are used to manage a
bank’s on-balance-sheet assets and liabilities as an end user is not nearly so robust,
however. Even as to futures contracts, where there is daily mark to market for changes
in value, there is not always disclosure about those on-balance-sheet cash items
related to “hedging” of assets or liabilities. Disclosure about the realized and
unrealized gains and losses on non-exchange-traded forwards and options and swaps
is also often not robust. The explanation of why the contracts are entered is often
slight. Disclosure about open contracts and contracts settled or offset with other
contracts is also often less than robust. In short, the disclo sures need to be improved
so that investors may make better and more well-informed decisions.

I recently attended a meeting at the FASB where the participants were discussing
accounting for hedging instruments and off-balance-sheet derivatives that are used
by banks as end users. One banker said that the off-balance-sheet instruments are
like on-balance-sheet instruments but involve no initial cash outflow, or cost, or no

262 ACCOUNTING STANDARD SETTING AND REGULATION

initial cash inflow, or proceeds. That description is, I think, apt. What it suggests to
me is that banks should consider giving investors as much information about the
off-balance-sheet items used by banks as end users to manage on-balance-sheet
assets and liabilities as they give for on-balance-sheet items. Notional amounts.
Strike prices. Interest rates. Due dates. The amounts of cash that will flow in and out
depending on where interest rates go. When cash receipts will come in. When cash
payments will go out. Activity in contracts. Unrealized gains and losses or
replacement value of contracts. Deferred gains and losses. When, period by period,
deferred gains and losses will be recognized in income, and the amounts thereof.
The effect of those instruments on net interest income or margin. Why the bank is
entering into such contracts. Whether it will enter into such contracts in the future.
What the bank is doing to prevent counterparty credit loss. The effects of netting
agreements including disclosure about legal enforceability. With that information,
investors can make judgments about future income and future net cash flow both for
what is on the balance sheet and what is not on the balance sheet. Until the FASB
decides what the accounting and related disclosures should be for the derivatives
used by banks as end users, I think voluntary disclosure of these kind of item will be
most helpful to investors.

At the 23 September 1993 meeting of the Emerging Issues Task Force, I made an
announcement of SEC staff positions on (1) the discount rate used to measure the
amount of defined pensions benefits under FASB Statement 87, Employers
Accounting for Pensions, and post-retirement benefits other than pensions under
FASB Statement 106, Employers’ Accounting for Post-retirement Benefits other than
Pensions; (2) the classification of in-substance foreclosed assets; and (3) the
reclassification of securities in anticipation of the adoption of FASB Statement 115.

The SEC staff expects registrants to use discount rates to measure obligations for
pension benefits and post-retirement benefits other than pensions that reflect the
current level of interest rates at each measurement date. Interest rates have declined
substantially and are at levels not seen in twenty years. In reviewing various filings,
we have found that registrants are not updating the discount rate assumption, and we
have required that it be done. We will be looking at future filings to make sure that
registrants are updating their assumption about discount rates. In that
announcement, we also said that we would expect the rate to be the rate of high-
quality bonds, which are the equivalent of AA-rated bonds.

Financial Reporting Release 28, Accounting for Loan Losses by Registrants Engaged
in Lending Activities, requires that in-substance foreclosed assets be classified and
accounted for as “other real estate owned.” On 10 June 1993, the banking
regulators jointly issued a regulatory credit initiative that is not consistent with the
guidance provided in FRR 28 because the regulatory initiative permits the
classification of ISF assets as loans rather than as real estate owned. Registrants have
asked whether SEC staff would object to the classification of ISF assets as loans in
financial statements and other financial information filed with the commission.

Even though the classification of ISF assets as loans is not consistent with the
guidance contained in FRR 28, it is the position of SEC staff that the

MARK TO MARKET ACCOUNTING 263

main objective of FRR 28 is to require a systematic methodology to be applied to the
recognition and measurement of ISF assets, and that this objective should be met
even if the classification pursuant to the regulatory credit initiative is adopted by
registrants. Therefore, the SEC staff would not object to the reclassification of ISF
assets as loans, provided that:

1 Registrants do not change their recognition and measurement accounting
policies for ISF assets.

2 Registrants file with the commission, in a current report, financial statements
and other financial information, including Guide 3 disclosures and
management’s discussion and analysis, that reflect the effects of the new
classification policy for ISF assets for each period for which such statements and
other financial information were provided in the most recent 10-K and
subsequent interim reports. This means that the staff would like registrants to
present the impact of the new reclassification policy on (a) the financial
statements for each of the latest three years, (b) each quarterly period since the
last form 10-K as well as comparable quarters for the preceding fiscal year, and
(c) all other financial information, including Guide 3 disclosures and
management’s discussion and analysis, for each period for which such
statements and other financial information were provided.

3 There is disclosure of the reclassification and its effects.

The SEC staff will object if, because of the adoption of this new regulatory initiative,
ISF assets are not classified consistently. Therefore, registrants should not adopt this
initiative on a prospective basis, because the financial statements and other financial
information would not be presented in a consistent manner.

FASB Statement 114 is silent on the issue of classification. Paragraph 26 of FASB
Statement 114 states that annual financial statements shall not be restated, but it
does not state whether annual financial statements should be retrospec tively
reclassified to present ISF assets consistently. I think that investors would be better
informed if the financial statements for all periods had the amounts for ISF assets
classified and displayed consistently, rather than having a disjointed presentation
that may confuse investors.

Statement of Financial Accounting Standards No. 115, Accounting for Certain
Investments in Debt and Equity Securities, requires an investment in a security to be
classified as held to maturity, available for sale, or trading, based on an enterprise’s
intent with respect to holding the security. The staff understands that the
anticipated adoption of Statement 115 and possible changes in regulatory capital
requirements may have caused registrants to change their intent with respect to
holding certain securities. As a result, for financial reporting purposes, these
registrants may need to change their classification of certain securities to reflect that
revised intent

The SEC staff has been asked whether such a change in classification would call
into question the prior accounting for securities. The staff will not challenge a

264 ACCOUNTING STANDARD SETTING AND REGULATION

registrant’s prior accounting for securities as a result of a one-time change in the
classification of securities on, or prior to, the date of adopting Statement 115 if that
change is caused by a change in intent because of the anticipated adoption of
Statement 115 and possible changes in the regulatory capital requirements.
However, registrants should not change the measurement principles for securities
prior to the adoption of Statement 115.

MARK TO MARKET ACCOUNTING 265

40
Financial accounting and reporting in our

worldwide economy
Remarks in the Distinguished Lecture Series at the University of

Texas at Austin, 12 November 1993

Thank you very much for inviting me to speak in this Distinguished Lecture Series.
My remarks represent my views and mine alone, and I do not speak for the
commission or other members of the staff.

I want to talk today about financial accounting and reporting in the United
States and in our worldwide economy and how important that reporting is. Before I
launch into that topic in general, it may be helpful if I set the stage by a brief
description of what the Securities and Exchange Commission is and does.

The US Securities and Exchange Commission’s mission is to administer federal
securities laws that seek to provide protection for investors. The purpose of these
laws is to ensure that the securities markets are fair and honest and to provide the
means to enforce the securities laws through sanctions where necessary. Laws
administered by the Commission are the Securities Act of 1933, Securities Exchange
Act of 1934, Public Utility Holding Company Act of 1935, Trust Indenture Act of
1939, Investment Company Act of 1940, and Investment Advisers Act of 1940.

Congress created the Securities and Exchange Commission in 1934 in the
Securities Exchange Act. The SEC is an independent, non-partisan regulatory
agency.

The commission is composed of five members, a chairman and four
commissioners. Commission members are appointed by the President, with the
advice and consent of the Senate, for five-year terms. The chairman is designated by
the President. Terms are staggered; one expires on June 5th of every year. Not more
than three members may be of the same political party.

Under the direction of the chairman and commissioners, the staff ensures that
publicly held entities, broker/dealers in securities, investment companies and
advisers, and other participants in the securities markets comply with federal
securities laws. These laws were designed to facilitate informed investment analysis
and decisions by the investing public, primarily by ensuring adequate disclosure of
material information. However, conformance with federal securities laws and

regulations does not imply merit. The commission does not pass on the merits of a
particular security. If information essential to an informed investment analysis is
properly disclosed, the commission cannot bar the sale of securities that analysis
may show to be of questionable value. It is the investor, not the commission, who
must make the judgment of the worth of securities offered for sale.

The commission’s staff is composed of lawyers, accountants, financial analysts
and examiners, engineers, investigators, economists, and other professionals. The staff
is divided into divisions and offices (including twelve regional and district offices),
each directed by officials appointed by the chairman. At this time, the staff numbers
about 2,700. The commission’s annual budget is about $260 million, which works
out to about $96,000 per person.

The commission staff is organized into divisions and offices with specific areas of
responsibility for various segments of the federal securities laws.

The divisions are Enforcement, Corporation Finance, Market Regulation, and
Investment Management. The Office of General Counsel serves as the chief legal
officer for the commission. As such, it is responsible for appellate litigation and
conducting disciplinary proceedings against professionals, as well as certain other
legal matters.

Other offices are those of the Chief Accountant, International Affairs, Legislative
Affairs, Economic Analysis, Administrative Law Judges, Secretary, and Inspector
General.

The Corporation Finance Division has overall responsibility for reviewing
disclosure documents filed by publicly held companies registered with the
commission. This division has about 325 lawyers, accountants, analysts, and
administrative staff. Its work includes reviewing registration statements for new
security issuances, secondary offerings of securities, proxy material, and annual
reports that the commission requires from publicly held companies, documents
concerning tender offers, and mergers and acquisitions in general. About 13,400
public companies file registration statements, annual reports, and proxy statements
with this division.

The Market Regulation Division is responsible for oversight of activity in the
secondary markets—registration and regulation of broker/dealers, oversight of the
self-regulatory organizations (such as the nation’s stock exchanges), and oversight of
other participants in the secondary markets (such as transfer agents and clearing
organizations). This division employs about 175 people.

The financial responsibility of broker/dealers, trading and sales practices, policies
affecting operation of the securities markets, and surveillance fall under the purview
of this division. In addition, it carries out activities aimed at achieving the goal of a
national market system set forth in the Securities Act Amendments of 1975. The
division also oversees the Securities Investor Protection Corporation and the
Municipal Securities Rulemaking Board.

The Investment Management Division, with about 165 people, has basic
responsibility for the Investment Company Act of 1940 and the Investment

MARK TO MARKET ACCOUNTING 267

Advisers Act of 1940. In 1985, it assumed responsibility for administering the
Public Utility Holding Company Act of 1935.

The division staff ensures compliance with regulations regarding the registration,
financial responsibility, sales practices, and advertising of mutual funds and
investment advisers. New products offered by these entities are also reviewed by the
staff in this division. This division also processes investment company registration
statements, proxy statements, and periodic reports under the Securities Act. If you
look in your daily newspaper, USA Today, you will see listed about 4,000 mutual
funds, all of which are overseen by the Investment Management Division.

The Enforcement Division, employing about 315 lawyers and accountants, but
mostly lawyers, is charged with enforcing federal securities laws. Enforcement
responsibilities include investigating possible violations of federal securities laws and
recommending appropriate remedies for consideration by the commission. Possible
violations may come to light through the Enforcement Division’s own inquiries,
through referrals from other divisions of the commission, from outside sources such
as the self-regulatory organizations, or by other means.

When possible violations of federal securities laws warrant further investigation
by its staff, the commission is consulted before proceeding. The commission’s
decisions may result in issuing subpoenas, formal orders of investigation, or other
means of proceeding with actions. At the conclusion of investigations, the
commission may authorize the staff to proceed with injunctions preventing further
violative conduct, with administrative proceedings in the case of entities directly
regulated by the commission, or with other remedies as appropriate.

In recent years, the Enforcement Division has been involved with such matters as
the Drexel Burnham Lambert affair, which resulted in disgorgements and fines of
more than $600 million; Salomon Bros and the US Treasury bond market affair,
which resulted in fines and other payments totalling $290 million; and, just two
weeks or so ago, the Prudential Securities matter, involving limited partnerships
where Prudential will create a fund of more than $330 million for settlement with
investors.

The Office of the Chief Accountant comprises the chief accountant, the deputy
chief accountant, four associate chiefs, five assistant chiefs, five professional
accounting fellows, one academic fellow, the chief accountant’s counsel, one
individual who is our liaison with state boards of accountancy and other bodies, and
four secretarial/administrative staff. We spend about 30 percent of our time on
registrant issues concerning accounting, 10 percent in rule making, 15 percent in
enforcement, 30 percent in oversight of private-sector standard-setting bodies, the
Financial Accounting Standards Board, and the American Institute of Certified
Public Accountants’ Accounting Standards Executive Committee and the Auditing
Standards Board, and the remainder on congressional and administrative matters.

The chief accountant consults with representatives of the accounting profession
and the standard-setting bodies designated by the profession regarding the
promulgation by those bodies of new or revised accounting and auditing standards.
This implements a major SEC objective to improve accounting and auditing

268 ACCOUNTING STANDARD SETTING AND REGULATION

standards and to maintain high standards of professional conduct by independent
accountants.

This office also drafts rules and regulations prescribing requirements for financial
statements. Many of the accounting rules are embodied in Regulation S-X, adopted
by the commission. Regulation S-X, together with the generally accepted accounting
principles promulgated by the profession’s standard-setting bodies and a number of
opinions issued by the commission as “Accounting Series Releases” or “Financial
Reporting Releases,” govern the form and content of most of the financial
statements filed with the SEC by public companies, broker/dealers, and mutual
funds.

This office administers the commission’s statutes and rules requiring that
accountants auditing financial statements filed with the SEC be independent of
their clients. This office also initiates proceedings under Rule 2(e) of the
commission’s rules of practice, which specifies reasons why an accountant may be
denied the privilege of practicing before the commission. These reasons include lack
of character or integrity, lack of qualifications to represent others, unethical or
unprofessional conduct, or the willful violation of (or the willful aiding and abetting
of a violation of) any of the federal securities laws, rules, or regulations. The chief
accountant also reviews the procedures followed in other accounting investigations
conducted by commission staff.

Let me now turn to the function of accounting standard setting and the place it
occupies in our financial markets. Financial statements and related disclosures, as we
know them here in the United States, are the lubricant that allows our capital
markets engine to turn at very high RPMs without overheating. There are about 13,
400 public companies here in the USA, running from giants like General Motors,
General Electric, General Mills, General Dynamics, and General Reinsurance with
billions in assets and revenues and millions of shareholders down to the small
limited partnership that has perhaps only 500 owners and a million or two in assets
and revenue. There are about 4,000 mutual funds like Fidelity’s Magellan and
Vanguard’s Windsor, which are giants managing many billions in assets. And about
8,000 broker/dealers like Merrill Lynch and Charles Schwab. They are all required
to prepare financial statements in conformity with generally accepted accounting
principles, file those financial statements with the SEC, and send them to
shareholders or customers.

After the market crash in 1929 and the subsequent depression—the Great
Depression—when the Dow Jones average lost 89 percent of its value, Congress, in
setting up the SEC, looked at the question of whether financial statements of public
companies should be audited by government auditors. The public accounting
profession persuaded Congress that audits should be left in the private sector.
However, Congress specifically empowered the SEC to prescribe accounting
standards for the preparation of financial statements. In 1938, the commission
stated that financial statements that were not prepared in accordance with principles
having “substantial authoritative support” would be presumed to be misleading.
The American Institute of Certified Public Accountants promptly created the

MARK TO MARKET ACCOUNTING 269

Committee on Accounting Procedure to set standards that would provide the
“substantial authoritative support” sought by the commission. That committee,
during its lifetime from 1939 through 1959, issued fifty-one Accounting Research
Bulletins, some of which, in one form or another, are still applicable today. For
example, the bulletins on inventory costing and consolidation continue in force.
The essence of the bulletins on deferred income tax accounting, although amended
many times, survive today, that is, there should be accounting recognition of
differences between taxable income and financial statement income reported to
shareholders.

The Committee on Accounting Procedure was succeeded in 1959 by the
Accounting Principles Board. The APB was also an arm of the AICPA and in fact
turned out APB opinions much the same way the Committee on Accounting
Procedure turned out bulletins. The APB, which lasted from 1959 through 1973,
turned out thirty-one opinions, many of which survive today in one form or
another. For example, APB Opinion 15 on earnings per share and APB Opinion 16
on business combinations continue to be used today, every day.

The independence of the APB began to be questioned in the late 1960s and early
1970s, and it gave way to the Financial Accounting Standards Board in 1973. The
FASB is not an arm of the AICPA or any other organization. It is independent. It is
funded by contributions from AICPA members, corporations, and, to a very small
extent, individuals, and the sale of its publications and research documents.

Since 1973, the FASB has issued 117 statements on financial accounting
standards and about sixty interpretations and technical bulletins. I signed the first
twelve statements and nine interpretations.

Pursuant to an ethics rule, members of the AICPA must, in reporting on the
financial statements of their clients, determine that those clients observed those
various bulletins, opinions, and statements in the preparation of their financial
statements in order for those financial statements to be in conformity with generally
accepted accounting principles. The SEC’s rules require that public company
registrants, mutual funds, and broker/dealers prepare their financial statements in
conformity with those same generally accepted accounting principles, which include
those bulletins, opinions, and statements.

These standard-setting bodies have, in the preparation and issuance of standards,
expressly said that financial statements should be prepared for use by investors in,
and prospective investors in, the securities issued by the enterprise preparing and
issuing the financial statement. This perspective is called the capital-markets
perspective. The FASB has said that financial statements, in order to be useful for
decision making by users of financial statements, should be relevant, reliable,
neutral, comparable, free of bias, even-handed, and representationally faithful. The
FASB, when it explicitly set out these qualitative characteristics, added powerfully to
the capital-markets perspective. Today, financial statements prepared by companies
following US generally accepted accounting principles are highly transparent and
credible. These financial statements are relied on by investors.

270 ACCOUNTING STANDARD SETTING AND REGULATION

One of the reasons for this country’s deep and highly liquid financial markets is
relevant, reliable, transparent, and credible financial statements. We have over fifty
million individual investors in this country and many thousands of institutional
investors, ranging from the likes of the trust department of the local bank to the
huge pension funds. For example, here in Texas there is the Texas State Teachers
Retirement System, which manages upwards of $31 billion of assets. The California
Public Employees Retirement System manages $69 billion of assets. TIAA/CREF,
the college school system retirement vehicle, has assets of about $110 billion; it is
the largest in the world. The various pension and retirement plans of General
Motors manage assets of more than $40 billion; General Electric’s various pension
plans’ assets exceed $36 billion. The open-ended mutual fund industry manages $1.
9 trillion in assets. All of these fifty million individuals, and all of these mutual
funds and institutions, use financial statements issued by public companies to make
investment decisions, and those investors are able to rely an those financial statements.

In most other English-speaking countries, for example Canada, Great Britain,
Australia, and New Zealand, accounting systems and the resulting financial
statements are also fairly transparent. However, the financial statements issued by
companies in those countries are not comparable with those issued by companies
here in the USA. For example, companies in Great Britain often write up their fixed
assets from historical cost to theoretical replacement value, and companies in
Canada defer transaction gains and losses on their debts denominated in foreign
currency, whereas US companies do not.

There are other major differences between what US companies do and what
companies in those countries do. However, financial statements issued by
companies in those countries are somewhat transparent, and the investor can see
what the accounting is and make whatever adjustments considered necessary or
desirable so as to make informed investment decisions. These countries have also
adopted a capital-markets perspective, although they may not yet have advanced the
capital-markets ideas as far as we have here in the United States. There are, in fact,
many substantial differences between US accounting standards and the standards
followed in other English-speaking countries.

However, many other countries have not yet adopted the capital-markets
perspective in the preparation of financial statements. They have other objectives in
mind. For example, in Japan, determining taxable income may take precedence over
determining income from the perspective of investors. I recently saw an article in
the business press to the effect that a major Japanese bank was going to recognize in
income its losses from bad loans over five years. It is widely reported that many
Japanese financial institutions have yet to recognize the decline in the value of their
investments in stocks and real estate, some of which have declined in value by 50
percent or more in the past three years. Japanese companies, as I understand it, do
not consolidate some or all subsidiaries’ financial statements and account for the
investments in stocks of subsidiaries at cost without elimination of inter-company
profits on asset transfers such as inventory.

MARK TO MARKET ACCOUNTING 271

In Europe, particularly in Germany, the use of so-called hidden reserves and
other practices such as not consolidating the financial statements of subsidiaries
mask the true financial position and income of German companies. We recently saw
a dramatic example of that. Earlier this year, Daimler Benz, the auto manufacturer,
became the first and so far only German company to have its shares listed on the
New York Stock Exchange. The SEC’s rules require that, when foreign companies
come to our shores to list their securities, they must prepare their financial
statements in conformity with US accounting standards or reconcile their home-
country financial statements to what the results would be using US accounting
standards. Daimler Benz reconciled its financial statements. Here are the results.
Under German accounting, Daimler Benz’s shareholders’ equity at 31 December
1992 was 11.5 billion Deutschmarks; under US accounting, equity was DM16
billion, an increase of about 40 percent. For the six months ended 30 June 1993,
net income under German accounting was DM168 million; under US standards,
Daimler Benz reported a net loss of DM949 million—a swing of more than DM1
billion, or $600 million.

While we have over fifty million individuals here in the USA who are investors in
their own right, and many more indirect investors through retirement plans,
individuals in Japan, Germany, and other European companies do not invest very
much of their assets in securities issued by public companies in those markets. There
is now quite a drive going on for companies in those countries to adopt accounting
policies that will result in more relevant, reliable, and transparent financial
statements. More than 550 foreign companies, including as Daimler Benz, Royal
Dutch Shell, Smithkline Beecham, Telefonos de Mexico, Glaxo, Akzo, Sony,
Toyota, and Honda, now have securities listed and traded in this country. I think
that number will increase.

In the USA, we have one of the largest pools of capital available in the world. I
believe that as companies in Europe need money for expansion, as European
countries privatize some of their state-owned companies, as countries in the old
Soviet bloc privatize their industries, as companies in less developed countries reach
for capital to build things like roads, bridges, and telephone systems, not to mention
factories that will produce consumer goods, they will increasingly come to US
capital markets and prepare their financial statements under, or reconcile those
statements to, US generally accepted accounting standards, which produce relevant,
reliable, and credible information. Working with those companies is a high priority
at the commission. The staff would like to bring as many of these investment
opportunities to the USA as possible while maintaining the high-quality disclosures
and accounting practices that investors in US capital markets have every right to
expect.

In summary, the current accounting and disclosure operations of the SEC are
premised on the need to provide clear, comparable, and understandable information
to capital markets. Since the 1930s, the commission has worked with registrants and
the accounting profession in this country to achieve that objective, and in more
recent years we have begun to work with companies and standard setters around the

272 ACCOUNTING STANDARD SETTING AND REGULATION

world. And I am convinced that the capital-markets perspective will be adopted, not
because the US Securities and Exchange Commission wants it, but because investors
around the globe need it to make informed investment decisions.

Thank you. I will be happy to answer any questions.

MARK TO MARKET ACCOUNTING 273

41
SEC accounting update

Remarks to the Nineteenth Annual AICPA National Conference on

Banking, Grand Hyatt Hotel, Washington, 4 November 1994

Introduction

I am pleased to speak at this conference again and to share this session with my
former partner, John Shanahan, and the chairman of the FASB, Denny Beresford.

These remarks represent my views and mine alone. I do not speak for the
Commission or other members of the staff. I will be making remarks regarding
disclosures about derivatives, accounting for derivatives, and internal audit
outsourcing.

Disclosures about derivatives

Dealing first with disclosures about derivatives, I want to compliment the FASB for
its speed in addressing additional disclosure issues in FASB Statement 119. From
start to finish, that document took the FASB less than a year to complete. While I
have not gone back and looked at prior FASB statements, I doubt that many have
been started and finished in less than a year. In addition to the speed of issuing
Statement 119, I think that 119 is a significant step in improving disclosures about
derivative financial instruments.

In Statement 119, the FASB prescribed disclosures about the nature, terms, and
financial statement effects of derivatives. Statement 119 encourages, but does not
require, disclosure of quantitative information about market risks inherent in
derivative financial instruments. In May 1994, the SEC’s chairman, Arthur Levitt,
testified before the US House of Representatives Subcommittee on
Telecommunications and Finance on issues relating to financial derivatives. In that
testimony, Chairman Levitt stated that, for companies that file with the commission,
it is essential to disclose quantitative information about derivatives. He also stated
that the commission would be publishing guidance on disclosures about derivatives

and risk-management activities. The SEC’s staff is working on that disclosure
requirement. At this time, I do not know when it will be issued or what form it will
take.

At this conference last year, I commented that companies that use derivatives for
purposes other than trading should provide disclosures about these instruments that
are similar to the disclosures required for on-balance-sheet financial instruments,
such as debt securities held as assets. I mentioned that the purpose of these
disclosures is to provide investors with an appropriate amount of information about
derivatives so they can make judgments about future income and future net cash
flows from both derivatives and on-balance-sheet financial instruments. Based on
the filings that I have looked at, it appears that many banks have improved, or at
least are well on their way to improving, their disclosures about derivatives.
Investors will thus be able to make more informed judgments about the banks’ cash
and derivatives positions and future earnings and future cash flows.

This year, I would like to focus on improving the way that registrants describe
their overall risk-management activities, not just their derivatives activities. In other
words, I would like to suggest that the disclosures about derivatives and cash
positions be supplemented with information that brings the entire risk-management
function together so that investors can understand better how the company
manages its overall financial risks. Specifically, I would like to encourage registrants
to concentrate on quantitative disclosures about market risks inherent in on- and
off-balance-sheet financial instruments and to discuss how these risks are managed.

Quantitative measures of market risk are used frequently by many banking and
non-banking registrants for internal risk-management purposes; however,
disclosures about these market risk-management techniques are generally not
contained in filings with the commission. Therefore, a gap often exists between the
way a company measures and assesses its market risks and the way investors think a
company may measure and assess its market risks. I suggest that this gap be closed.
The Group of 10 encourages this disclosure and suggests that this information gap
can cause a misallocation of capital among companies and can also amplify market
disturbances. That conclusion by the Group of 10 seems intuitively to be correct.

While several quantitative measures are used by companies in their internal risk-
management systems, the Group of 10 and the Group of 30 recommend “value at
risk” as a measure of market risk. The Financial Executives Institute also recently
endorsed disclosures about value at risk. Value at risk is a measure of the potential
loss resulting from hypothetical changes in market factors, such as interest rates and
foreign currency exchange rates, for a given time period. It is used to measure the
potential changes in the fair values of financial instruments arising from changes in
market prices or yields. For example, value at risk would be an estimate of loss for a
statistically calculated hypothetical change in interest rates of, say, 100 basis points.

Although this measure may initially sound complex and potentially costly to
calculate, at least one large bank is making much of the data needed for this
computation available at little or no cost. I’m sure that we will hear more about the
potential costs and benefits of making these computations and of disclosing them.

ACCOUNTING STANDARD SETTING AND REGULATION 275

An abbreviated sample of a value-at-risk disclosure might be something like the
following:

As of 31 December 1994, the value at risk for all financial instruments, including
derivatives, amounted to $x million for interest rate movements and $y million for
foreign exchange movements. Value at risk is defined by the company as the
potential loss from adverse market movements that would cover 99 percent of
possible adverse movements during a one-day period.

From that disclosure, investors would have an indication that for ninety-nine
days out of a hundred the value of the portfolio would be expected to lose no more
than $x million because of adverse interest rate changes and no more than $y million
because of adverse changes in foreign currency exchange rates.

This information, supplemented with a qualitative discussion about how a
company manages risk and how much risk the company is willing to tolerate, would
allow investors to understand better the market risks of a company’s portfolio. Also,
investors would be better able to compare, quantitatively, the market risks of one
company with the market risks of another. This type of information should improve
an investor’s understanding of the potential risks and returns of two or more
potential investments.

Accounting for derivatives

Next, let’s discuss accounting for derivatives. At or about the time of Chairman
Levitt’s testimony to Congress in May 1994, the Division of Corporation Finance
formed a task force to review derivative disclosures for approximately 100 banking
registrants and 400 non-banking registrants. The primary objectives of this task
force are to (1) learn why and how companies are using derivatives, (2) understand
better the current types of disclosure about derivatives, (3) improve disclosures
about derivatives, and (4) form a basis from which the commission could develop
guidance regarding disclosures about derivatives.

One of the outcomes of the Corporation Finance Division’s project on
derivatives is that the SEC staff has learned more about how registrants account for
derivatives. We have learned that companies that are parties to highly leveraged
interest rate swaps are marking those swaps to fair value and including the mark in
income. Companies that are parties to interest rate swaps with some form of mild
embedded written option are accounting for those swaps more or less on the cash
basis in that the swap is not being marked to fair value, even though, if the written
option portion of the swap were a free-standing instrument, it would be marked to
fair value as are other written options. The SEC staff is following closely
developments by the FASB in its project on hedge accounting. Until these issues are
resolved, registrants are encouraged to disclose descriptive numerical information
about swaps and other instruments that have embedded written options so that
investors can come to grips with what the entity is doing.

There was some publicity, about a month or two ago, that the commission or its
staff was about to issue some guidance or rules on the accounting for certain kinds of

276 MARK TO MARKET ACCOUNTING

swap. That position was somehow inferred from some informal discussions with our
staff. Although we are considering additional quantitative disclosures at this time, the
staff does not plan to issue guidance or recommend specific accounting rules in this
area. That is not to say that we will not find that a registrant, in its specific
circumstances, has not accounted for certain swaps correctly, which accounting may
require revision. But that determination will have to be made on a case-by-case
basis.

Internal audit outsourcing

The last issue I will discuss is internal audit outsourcing. With increasing worldwide
competition from financial intermediaries, banks and other financial institutions are
forced to work smarter and become more cost-efficient. To do this, several have
begun to contract out, or “outsource,” various functions. For example, I recently
read an article that indicated that several banks were outsourcing their legal work,
data-processing functions, mutual fund back-office work, and property
management. Moreover, some banks are beginning to outsource their internal audit
function.

I understand that many different alternatives are available to a company that wishes
to outsource its internal audit function. One alternative being considered by some is
for a company to replace completely its internal audit function with an “expanded”
external audit function. As a result, the external auditor would perform both the
external audit functions and the functions previously performed by the internal
audit department. That is, the external auditor would be responsible for (1)
performing audit procedures and issuing an opinion on whether the financial
statements were prepared in conformity with generally accepted accounting
practices, (2) issuing another opinion on management as assertions regarding the
effectiveness of the company’s internal controls, and (3) designing and executing
audit procedures that traditionally were performed by the internal auditors. Because
external auditors must be independent, in fact and in appearance, of the company
being audited, external auditors attempting to attend to both the responsibilities of
the external auditor and the responsibilities traditionally performed by the internal
audit function must exercise great care.

In 1993, the AICPA issued Ethics Ruling 97, Performance of Certain Extended
Audit Services, which addresses independence issues relating to internal audit
outsourcing. That ruling highlights that external auditors (1) cannot perform
management functions or make management decisions, (2) cannot be part of the
client’s approval process, or (3) cannot be part of the internal control system,
without impairing their independence.

The guidance in Ruling 97, read carefully, is very restrictive. The auditor cannot
perform management functions or make management decisions. This means, for
example, that the auditor cannot determine the projects to be performed under the
scope of the “internal audit” work. Also, the auditor cannot become part of the
approval process for specific transactions, such as the loan-approval process, because

ACCOUNTING STANDARD SETTING AND REGULATION 277

that is a management function. In addition, to the extent that federal or state
banking regulations require an internal auditor to be under the control of
management, the agreement by an outsourcer to func-tion in that employee role is
fundamentally inconsistent with the notion that for external audit purposes this same
auditor would be considered independent from that management.

The SEC staff has informally advised external auditors that it would question
independence, consistent with Ruling 97, when external auditors perform
procedures that are management functions or internal control functions.
Practitioners are advised to give careful consideration to the implications that attend
such outsourcing arrangements and the resulting effect on the accountant’s
independence.

That concludes my prepared remarks. I would be happy to respond to questions.

278 MARK TO MARKET ACCOUNTING

42
A review of the FASB’s accomplishments since

its inception in 1973
Remarks to the Twenty-second Annual AICPA National Conference,

Washington, 10 January 1995

Good morning. I am pleased to be invited to speak at this national conference on
SEC developments. I need to give the standard disclaimer. I am speaking for myself
and not for the commission or any of the other staff.

I have on occasion been critical about certain financial accounting and reporting
issues. Today, I want to mention some of the positive things in financial accounting
and reporting.

When David Tweedie, now Sir David, commenced his chairmanship of the UK’s
equivalent of our Financial Accounting Standards Board, he quipped: “There are only
three things wrong with accounting—the balance sheet, the income statement, and
the cash flow statement.” That was about five years ago, and I am pleased to report
that Sir David’s Accounting Standards Board is making good headway in improving
accounting in the UK. I am pleased to say that the FASB is also making good
headway in improving accounting here in the United States.

The FASB’s mission statement says that its mission is to “improve standards of
financial accounting and reporting for the guidance and education of the public,
including issuers, auditors, and users of financial information.” I think that the
FASB is doing just that.

Last month, the FASB hit a pothole in its road to improving the accounting here
in the USA. As most of you know by now, and no doubt will hear more about today
and tomorrow, the FASB decided to back away from its proposal to require that the
value of fixed stock options issued to employees be charged to expense. Instead, the
board decided to require disclosure of that value if a company chooses not to
formally recognize that value as an expense in its income statement. Many who had
opposed expensing favored explicit disclosure of the value of stock options granted
to employees. Given the great degree of opposition to its proposal and the clear
danger that Congress would get involved with legislation, I believe that the FASB
acted wisely to end the controversy by requiring disclosure instead of formal
recognition in expense of the value of stock options. The FASB has, in my opinion,

been good for investors. Very good for investors. I want the FASB to continue to do
good work for investors. I do not want the FASB legislated out of existence. Were
that to happen, I think that investors would get the short end of that stick.

Let me briefly review some of the FASB’s major outputs since its inception in
1973. Time does not permit a review of all of them. When the FASB got started in
1973, a lot of the tires on the accounting vehicle were flat or very low on air. A few
had ruptured, blown out so to speak.

Some companies were capitalizing research and development costs, and some
were charging the costs to expense when incurred. Disclosures were non-existent or
not very clear. FASB Statement 2 was quickly issued in 1974, and since then all
R&D costs have been charged to expense when incurred, except for those costs
incurred on R&D contracts for third parties. And there is disclosure by companies
in their annual reports of the amount of R&D costs for the year.

Some insurance companies were recognizing, in advance of the event and maybe
even in advance of writing a policy and collecting a premium, losses from future
catastrophes such as hurricanes and ice storms. Some commercial and industrial
companies were also recognizing other types of loss in advance of the event. FASB
Statement 5, issued in 1975, precluded the recognition of those kinds of loss in
advance of the event triggering the loss. I will note, in passing, that there has been
some backsliding on this score recently in so-called “restruc turing charges,” where
losses are being recognized in advance of the event, but I will not get into that
matter here today.

How to account for operations in foreign countries and how to translate foreign
currency monetary items and what to do with foreign currency transaction gains
and losses was quite muddled when the FASB started business in 1973. Statement 8
quickly resolved that very complex area in 1975. However, Statement 8 produced
results that were thought to be extreme, so it was changed by Statement 52 in 1981,
and the world seems to be fairly well satisfied with how Statement 52 works and the
results it produces. Statement 52’s “hedging” provisions will be changed based on
the direction the FASB is going on its hedging project, and we will hear about that
this afternoon from Jim Leisenring.

Segment disclosures were covered by the board in Statement 14, issued in 1976.
This is probably the one FASB standard that has not measured up to what financial
statement analysts believe ought to be reported by issuers. The FASB and the
Canadian Institute of Chartered Accountants, working together, are considering
again what companies should report by way of segment data. At the same time, the
International Accounting Standards Committee is also working on an international
standard on segment reporting.

When one looks at income statements of corporate America, one sees that
employee-related costs comprise more than 50 percent of total costs. In Statements
87 and 106, the FASB has improved tremendously the recognition, measurement,
and disclosure rules for pension and post-retirement healthcare costs. There is now,
happily, great transparency in corporate America’s financial statements regarding
pension and post-retirement healthcare costs.

280 ACCOUNTING STANDARD SETTING AND REGULATION

In Statement 57, the board required the disclosure of the existence of related
party relationships and related party transactions. That required disclosure had
previously been contained only in the AICPA’s auditing literature. Many issuers of
financial statements were reluctant to provide related party disclosures prior to the
issuance of Statement 57. Now that the requirement is part of the formal body of
generally accepted accounting principles, it is easier to persuade issuers of the
necessity of the disclosures. Users of financial statements have been the beneficiaries
of the related party disclosures.

In Statement 91, on loan fees, the FASB rejected a most objectionable practice,
that is, crediting to income a fee received at the time a loan is originated. Prior to
that time, savings and loan associations and some banks and insurance companies
were recognizing income on the acquisition of an asset instead of when the asset
itself produced the income.

In Statement 95 on cash flow statements, the FASB hit a bases-clearing triple.
The old funds statement required by APB Opinion 15 simply was not very good,
although in its time it was a move forward in financial reporting. Had the board
required the direct method of reporting operating cash flows in Statement 95 as
investors and creditors wanted, as opposed to allowing the indirect method as
requested by issuers, the hit would have been a grand slam home run. But, in
issuing Statement 95, the board accepted the proposition that the costs of gathering
the data for presenting operating cash flows on the direct basis exceeded the benefits.

I must say that I have never understood the argument by issuers of financial
statements that excessive implementation costs are involved in gathering operating
cash flow information by type or source. All that is required is that cash payments
be coded as to type and then sorted. For example, cash payments to vendors for raw
materials. Cash payments to employees. Cash payments to advertisers. That seems
simple enough to me, especially in this day of computers. Likewise, cash receipts
can’t be hard to sort by type.

Inasmuch as investors and creditors believe that the information revealed by the
direct method of presenting operating cash flows is extremely relevant and inasmuch
as the costs of gathering the information cannot possibly be large, it seems to me
that a good case can be made for revising Statement 95 to require the direct method
of presenting operating cash flows. Moreover, I do not understand why issuers of
financial statements do not, of their own volition, provide operating cash flows
using the direct method. If the suppliers of capital want something, then the users
of capital, it seems to me, would, in their own best interests, give that something to
the suppliers of capital. In the end, those who furnish desired information to
suppliers of capital will see their cost of capital reduced by supplying that
information.

In Statements 105, 107, and now 119, the board made good progress on
disclosures about financial instruments. Although I wish the board had required
more specific, numerical-type disclosure by end users of their derivatives positions,
which the SEC will now have to require, the disclosure package is obviously

MARK TO MARKET ACCOUNTING 281

becoming more robust. The 1994 reporting season is now upon us, and I look
forward to seeing some rich disclosures about both cash and derivatives positions.

The critical thing now is to nail down the accounting for derivatives. As we all
know, the accounting literature that exists is inconsistent, and the existing litera-ture
does not deal with many of the accounting issues that issuers and their auditors
encounter. We will hear from Jim Leisenring this afternoon where the board stands
in the accounting for derivatives. Let me simply say at this point that I think it is
critical that the board move forward on the accounting issues as speedily as possible.

All of that said, the analysts—those who use financial reports—seem pretty
content with the current state of affairs, with a few exceptions. In 1993, the
Association for Investment Management and Research published a report entitled
Financial Reporting in the 1990s and Beyond. As I read that report in constant flow
from cover to cover, I have the impression that the AIMR folks are fairly well
pleased with the current state of affairs. They don’t want to move to more market
value accounting, although they favor disclosures about market values. They would
like more disaggregated information and would like it more often, say quarterly.
They would like more information about derivatives. They would recognize
liabilities for all executory contracts, and they would deduct goodwill from
shareholders’ equity. Now that really is not a very long wish list.

We will hear tomorrow from Ed Jenkins, who chaired the AICPA’s Special
Committee on Improving Business Reporting. Jenkins talked with a large number of
analysts and other users of financial reports. My impression is that he also found that
users of financial reports are pretty well pleased with the current state of financial
reporting, but his conclusions differ somewhat from the inferences that I draw from
the AIMR report.

Let me deal with one final issue in my remarks here this morning. At this
conference last year, I spoke critically about public accountants’ independence from
their clients and the objectivity of public accountants. The Public Oversight Board,
much to its credit, promptly appointed a distinguished panel to look into my
criticisms and make recommendations. The panelists were George Anderson,
formerly chairman of the AICPA, Don Kirk, formerly chairman of the FASB, and
Ralph Saul, formerly chairman of the American Stock Exchange. Don Kirk chaired
the panel, which reported its findings and recommendations in September.

The centerpiece of the Kirk Panel report is what is described as a three-part
package. I quote from page 23 of the report:

In summary, the Panel’s suggestions for strengthening the relationship
between the board of directors and the auditor are a three-part package. All
three steps are needed to ensure that the company’s financial reports meet the
shareholders’ need for relevant and reliable information. (1) The board must
recognize the primacy of its accountability to shareholders. (2) The auditor
must look to the board of directors as the client (3) The board must expect
and the auditor must deliver candid communication about the
appropriateness, not just acceptability, of accounting principles and estimates

282 ACCOUNTING STANDARD SETTING AND REGULATION

and the clarity of the related disclosures of financial information that the
company reports publicly.

I was pleased to hear, when the POB met with the commission about a
month ago, that the SEC Practice Section of the AICPA has appointed a task
force to consider the Kirk Panel’s report and make recommendations. I
understand that this task force has met several times and is considering what
to do. I am pleased about the promptness of the response to the criticisms
that I raised at this conference last year.

That concludes my remarks.

MARK TO MARKET ACCOUNTING 283

43
Current developments at the SEC

Remarks to the Seventeenth Annual SEC and Financial Reporting

Institute Conference, Leventhal School of Accounting, University of

Southern California, Los Angeles, 14 May 1998

There is nothing new under the sun on the accounting side at the Division of
Enforcement. Over the years, I have heard every chief accountant of the division
speak at forums like this one, and I have heard nothing new. There are only so
many ways to cook the books. I too am going to sound like a broken record.

Actually, I bring good news. Despite what we occasionally read in the press about
accounting lapses, from my perspective as chief accountant of the Enforcement
Division, financial accounting and reporting is in good shape. I say this based on
the number of open cases that the accounting staff is working on. These are the
cases involving accounting issues, financial statement disclosure issues, MD&A
disclosure issues, auditing issues, and auditor independence issues. And there are
one or two cases that potentially involve bribes paid by public companies to
government officials. We have between 200 and 250 open cases involving
accounting staff of the home office in Washington and the regional offices. Of the
200–250 cases, 120 are in the home office. Those 120 cases came onto our work
program as follows: 1991—two cases, one of which is on hold because there is an
ongoing criminal investigation and one of which is on appeal; 1992—one case,
which is in settlement negotiations; six cases were opened in 1993; twelve cases
originated in 1994; twenty-one started in 1995; twenty-four in 1996; forty-one
began in 1997; and to date in 1998, thirteen cases have been opened. These years
are calendar years, not commission years, which run from October through
September. In the home office, we have twenty accountants, so the workload is
about six cases per accountant.

When I look at the statistics of about 250 open accounting cases across the entire
commission, that compares very favorably with the total number of possible cases.
Those 250 cases arose over about a five-year period. Assuming that as many cases
were closed as were opened during that period (and I do know the actual number),
the 250 becomes 500. During that five-year period, approximately 15,000
registrants filed financial statements with the commission. Thus, over the five years,

there were 75,000 opportunities to get the accounting, auditing, and independence
right. Then, when I divide 500 cases by 75,000 opportunities, the result is about 0.7
percent. One of the old hands in the Enforcement Division tells me that it seems to
him that we bring about 100 accounting cases each year. If I divide 100 cases by 15,
000 opportunities, the result is about 0.7 percent. These percentages are very small.
To be sure, the percentages, whatever they are, are not Six Sigma, but nonetheless
they are very small. What that says to me is that, by and large, the participants in our
vast public marketplace are conforming to the rules.

The percentages would be cut about in half were I to include broker/dealers and
investment companies in the statistics. In addition to the 15,000–16,000 public
company registrants that file financial statements and audit reports with the SEC,
there are about 7,000 broker/dealers and about 7,000 investment companies that
also file financial statements and audit reports with the SEC. So if I add 7,000
broker/dealers and 7,000 investment companies to the 15,000–16,000 issuer/
registrants, the total is about 30,000. Then 100 cases divided by 30,000
opportunities equals 0.3 percent. Over the years, we have had only a limited
number of accounting cases involving broker/dealers and mutual funds. I think that
it is instructive to observe why that is. I think that there are not many cases
involving broker/dealers and investment companies because those companies mark
their assets to market.

Let me now turn to the kind of problem that we accountants in the Enforcement
Division actually work on. In the six months that I have had to look at the
problems, I see that we do not deal much with esoteric accounting problems such as
foreign currency translation or the in and outs of pension accounting or post-
retirement benefits other than pensions. We deal with more pedestrian issues. For
example, on the auditor independence issue, we have one case where the outside
auditors of a company wanting to raise money went around to their other clients
and promoted the stock of the issuer, passed out the subscriptions for the issuer’s
stock, and then took the checks that their clients wrote for the shares of the issuer’s
stock and delivered the checks to the issuer. The SEC has a very clear rule that says
that the external auditor may not be a broker for his or her client. So does the
AICPA.

Another independence case that we have is the one involving KPMG Peat
Marwick, which the commission filed in December 1997. The assertions by the
commission are as follows (I am quoting from the Commission’s order):

8 As described in detail below, in approximately January 1995, KPMG Peat
Marwick organized and capitalized KPMG BayMark, a purportedly
independent firm owned by Edward R.Olson and three others. KPMG Peat
Marwick planned to use KPMG BayMark as a vehicle to engage in new lines of
business, including the “corporate turnaround” business. Later in 1995, as part
of a turnaround engagement, KPMG BayMark installed its principal Olson as
the President/COO of Porta, a financially troubled audit client of KPMG Peat
Marwick’s Long Island office.

ACCOUNTING STANDARD SETTING AND REGULATION 285

9 When KPMG Peat Marwick audited Porta’s 1995 year-end financial
statements and prepared its audit report, KPMG Peat Marwick’s financial and
business relationship with its audit client Porta and with KPMG BayMark
impaired KPMG Peat Marwick’s independence from its audit client, in both
fact and appearance. In particular, KPMG Peat Marwick lacked independence
because: (1) KPMG Peat Marwick loaned $100,000 to the President/ COO of
its audit client Porta; (2) KPMG Peat Marwick capitalized the separate business
owned by the President/COO of its audit client Porta; (3) KPMG Peat
Marwick capitalized the “affiliate” of its audit client Porta; (4) KPMG Peat
Marwick was entitled to a percentage of the earnings, disposed inventory and
restructured debt of its audit client Porta; and (5) by reason of their contractual
ties and interdependence, KPMG Peat Marwick and KPMG BayMark should
be considered a single entity for independence purposes.

10 Despite warnings from the Commission’s OCA staff concerning independence
issues arising from its relationship with KPMG BayMark, KPMG Peat
Marwick completed its audit of Port’s 1995 year-end financial statements and
issued its “Independent Auditors’ Report,” dated March 22 1996, which
represented that it had conducted our audits in accordance with generally
accepted auditing standards’ (“GAAS”). Porta incorporated KPMG Peat
Marwick’s report as part of its 1995 annual report on Form 10-K, filed with
the Commission on April 2 1996.

KPMG has responded by denying the commission’s assertions about its lack of
independence. The matter will soon be heard by an administrative law judge.

Premature revenue recognition. Deferral in the balance sheet of costs that should
have been reported in income as operating expenses. Assigning inflated, often
outrageously inflated, dollar values to exchanges of non-monetary assets, particularly
with related parties. Assigning inflated, often outrageously inflated, dollar values to
non-monetary assets contributed to the corporation in exchange for stock of the
corporation. Not disclosing the existence of related parties and/or transactions with
related parties. Recognizing officers’ salaries as receivables. Recognizing cash taken
from the corporation by officers as cash in the bank or as a direct reduction of
stockholders’ equity instead of as a charge to expense. Bleeding into income,
without disclosure, “reserves” established in business combinations or in so-called
restructurings. Treasury stock carried as an asset in the balance sheet at market, with
gains on sale of treasury stock credited to income. (I’m not making this up.)
Increasing fixed assets and crediting cost of sales. Recognizing sales revenue when
right of return exists. Shipping products to company warehouses or employees’ homes
and recognizing sales revenue. Recognizing revenue in advance of the customer’s

286 MARK TO MARKET ACCOUNTING

acceptance of the product. Keeping the sales journal open after the end of the
quarter or year but backdating sales invoices. Not booking all of the accounts
payable; just put the invoices from suppliers into a desk drawer. Not writing down
or writing off uncollectible receivables. Booking barter trade credits as if they
represented bona fide US dollars. Such is the grist of our accounting mill. Not very
esoteric stuff. If I draw an analogy with police work, what we see is stolen
automobiles with fingerprints on the door handles, not murders where there are no
clues except for dogs that did not bark.

On the audit side, I have now seen several non-audits. Auditors accepting, with
little or no evidential support, values ascribed to both monetary and non-monetary
assets. Artwork by unknown artists booked as assets at huge amounts in non-
monetary exchanges but without any support for the assigned value and no inquiry
by the auditor about independent valuation of the artwork. Receivables acquired
from collection agencies for pennies but booked at dollars without any
documentation and no auditor inquiry as to the basis for the value. Auditors not
doing substantive audit work but relying on so-called analytical procedures where the
evidence, or lack thereof, cries out for substantive audit work. Auditors not doing
cut-off work for sales and purchases, with the result that sales of the next period are
booked in this period with a corresponding increase in receivables from customers,
and accounts payable for purchases of inventory of this period not booked until
next period with the inventory recognized in the balance sheet, resulting in
understated costs of sales and overstated margins. And we see cases where the
auditors were lied to or were not given all of the documentation that they should
have been given. But sometimes I wonder whether the auditors asked the right
questions.

Let me return to my major theme. Although the issues that we deal with in the
Enforcement Division are messy and quite distasteful, they are a very small fraction
of the universe. Maybe that is because marketplace participants know that the
Enforcement Division is paying attention to what goes on and that the penalty for
infractions is or can be quite severe. I am fairly well satisfied that the number of
transgressions that we see is quite small given the size of the population from which
they arise. The state of financial accounting and reporting is good, and we need to
keep it that way through constant vigilance.

The SEC’s enforcement program regarding practicing accountants is
accomplished primarily but not completely by bringing cases against accountants
under rule 102(e) of the SEC’s Rules of Practice. Rule 102(e) reads as follows:

The Commission may censure a person or deny, temporarily or permanently,
the privilege of appearing or practicing before it in any way to any person who
is found by the Commission after notice and opportunity for hearing in the
matter:

(i) Not to possess the requisite qualifications to represent others; or
(ii) To be lacking in character or integrity or to have engaged in unethical

or improper professional conduct; or

ACCOUNTING STANDARD SETTING AND REGULATION 287

(iii) To have wilfully violated, or wilfully aided and abetted the violation of
any provision of the federal securities laws or the rules and regulations
thereunder.

The Washington Court of Appeals, on 27 March 1998, remanded a case, the
Checkosky and Aldrich case, to the commission and instructed the commission to
dismiss the case. Briefly, the facts in the Checkosky case are as follows. Savin
Corporation, a Coopers and Lybrand client, in its 1981, 1982, 1983, and 1984
financial statements, deferred in its balance sheet “start-up” costs related to Savin’s
effort to develop and bring to market a copying machine. In 1985, pursuant to an
SEC enforcement action, Savin restated its 1983 and 1984 financial statements,
writing off the deferred start-up costs as R&D costs. The commission then brought
an administrative action against the Coopers’ audit partner and manager, asserting
that they had engaged in unprofessional conduct by allowing Savin to capitalize
start-up costs that should have been charged to expense as R&D costs.

In 1989, after a lengthy hearing, an administrative law judge found that
Checkosky and Aldrich had engaged in improper professional conduct by violating
generally accepted accounting practices and standards in five audits over four years
(1981–4) by allowing Savin to improperly defer $37 million of research and
development costs as start-up costs, and by failing to adequately audit the deferred
costs. The judge suspended the two auditors from practice before the commission
for five years. Checkosky and Aldrich appealed against the judge’s decision to the
commission. In 1992, the commission upheld the judge’s findings, determined that
Checkosky and Aldrich had acted recklessly, and stated that “a mental awareness
greater than negligence is not required for improper professional conduct” but
reduced the sanction to a two-year suspension. Two years later, in 1994, the DC
Circuit Court of Appeals remanded the Checkosky and Aldrich case back to the
commission with instructions to address its interpretation and application of rule 2
(e)(1)(ii). Over two years later, in January 1997, the commission issued an opinion
and order that affirmed its first opinion and order, based on Checkosky’s and
Aldrich’s reckless conduct, but added some language to which Commissioner
Johnson in January 1997 and the Court of Appeals on 27 March 1998, took
exception. The commission’s majority opinion stated: “We believe that Rule 2(e)(1)
(ii) does not mandate a particular mental state and that negligent action by a
professional may under certain circumstances constitute improper professional
conduct.” The Court of Appeals, in its decision pursuant to the second appeal, said
that “elementary administrative law norms of fair notice and reasoned decision
making demand that the Commission define those circumstances with some degree
of specificity. It has not done so.” The court went on to state “there are strong signs
that the Commission is unlikely to settle on a uniform theory as to the necessary
mental state for a violation of Rule 2(e)(1)(ii) anytime soon,” pointing to
Commissioner Johnson’s dissent in Checkosky, his separate concurrence in Potts,
and to Commissioner Wallman’s dissent in Potts. (Potts is another 2(e) case that is
on appeal.) The court concluded: “it would be futile to allow the SEC a third shot

288 MARK TO MARKET ACCOUNTING

at the target.” The case was remanded with instructions to dismiss the charges
against Checkosky and Aldrich.

Since Checkosky was handed down on March 27, the staff has been considering a
number of recommendations to the commission on how to respond to Checkosky.
One way, but it is only one way, would be for the commission to issue for review
and comment by the public a revised rule 102(e) wherein the commission would set
forth the standard that it will use in applying rule 102(e) against professionals. Just
last week, the American Institute of Certified Public Accountants petitioned the
commission to issue such a rule for review and comment. The AICPA’s petition was
accompanied by its proposed rule, which reads as follows:

“Improper professional conduct” as used herein shall mean conduct showing
that the professional is

1 substantially unfit to practice before the Commission by reason of:

a the commission of a knowing violation of applicable professional standards,
or

b conduct showing a conscious and deliberate disregard of applicable
professional standards, or

c a course or pattern of conduct showing repeated failure to conform to
applicable professional standards; and

2 constitutes a current threat to the integrity of the Commission’s processes or to
the financial reporting system; in each case found after due notice of the
conduct charged and a fair hearing thereon.

These criteria suggested by the AICPA would be very high hurdles indeed.
I obviously do not know how the commission is going to come down on this

matter or the form that a commission decision will take. All I can suggest is that you
stay tuned to this frequency.

The final matter that I want to raise today relates to fraternization between
auditors and their clients. It appears to me that some auditors and their families
through social contacts are getting so close to and so involved with their clients and
their clients’ families that a disinterested observer would question whether the
auditor’s objectivity had not been clouded or perhaps even enveloped. Let me give
you two examples. In Business Week (23 February 1998), there is an article that talks
about auditors and their families having social contacts with their clients and their
clients’ families through such joint activities as picnics and baseball games. The
Enforcement Division recently came across an audit planning memorandum of a
Big Six firm wherein social events between the auditor and client are explicitly set
forth. I quote from that memorandum (I have not used the names of sports teams
actually used in the memorandum. I have substituted other names.)

ACCOUNTING STANDARD SETTING AND REGULATION 289

• Summer and Other Social Events
• The University of Texas football games (Oklahoma, Texas A&M, and Arkansas)
• NCAA Basketball final four tickets
• San Antonio Spurs tickets
• Houston Astros tickets
• Shopping

I wonder what “shopping” means. Alpaca sweaters? Golf clubs? Bally leather jackets?
I wonder how investors or potential investors would react if they were aware of these

facts. Would investors believe that the auditor’s objectivity is not affected when the
auditor and his or her family are engaged in periodic baseball games and picnics
with the client and the client’s family? Would investors believe that the auditor’s
objectivity is not affected if the auditor and client personnel regularly attend
sporting events together? Whether paid for by the auditor or paid for by the client?
Would investors perceive that gift giving, whether from auditor to client or client to
auditor, can go on for very long without compromising the auditor’s objectivity?
How would an underwriter who is about to take $100 million of stock of that
company react to these facts? A mutual investment manager who is about to invest
$100 million in the stock of that company? Should auditors have to follow the same
rules with respect to their public company audit clients that I as an employee of the
US federal government have to follow with respect to regulated entities or persons? I
leave you to ponder those questions.

Postscript

Readers should refer to the postscript on page 230.

290 MARK TO MARKET ACCOUNTING

44
A memo to national and international

accounting and auditing standard setters and
securities regulators (a Christmas pony)

The 2001 R.J.Chambers Memorial Research Lecture, delivered in the Great Hall,
University of Sydney, Australia, 27 November 2001

Chancellor, Vice-Chancellor, distinguished guests. Thank you, Chancellor, for
those kind introductory words, and thank you Dean Wolnizer for the invitation to
present the R.J.Chambers Research Lecture. It is indeed a pleasure for me to be here
in Sydney delivering this lecture. I have long admired Professor Chambers’ work. I
wish I had met him.

I graduated from the University of Texas in Austin in the summer of 1957. I went
to work on 1 August 1957 for an accounting firm in San Antonio, Texas, by the
name of Eaton & Huddle. Tom Holton, one of the partners of Eaton & Huddle,
hired me. After Eaton & Huddle merged with Peat, Marwick, Mitchell & Co., now
KPMG, Tom Holton eventually became chairman of KPMG. Holton will attest
that I have been talking about, making speeches about, and generally advocating and
promoting market-value accounting since the late 1950s. By “market-value
accounting,” I mean estimated selling price for assets and estimated settlement price
for liabilities. Without knowing it, I was sounding like Chambers in the 1950s,
although not so eloquent.

I had not read Chambers until I joined the Financial Accounting Standards
Board. I was at the FASB from March 1973 through June 1976. While I was there,
I read Chambers’ book Accounting, Evaluation and Economic Behavior and
discovered that he and I shared the same view about accounting for assets.
Unfortunately, there was no way to get market-value accounting adopted by the
FASB in its early days. The climate was just not right. In fact, in 1975, when the
FASB issued Statement 12 on Accounting for Certain Marketable Securities, the FASB
could muster only three out of seven votes for mark-to-market accounting of
marketable equity securities.1 Similarly, in 1985, in FASB Statement 87 on
Employers’ Accounting for Pensions, the mark-to-market accounting for off-balance-

sheet pension plan assets, mostly stocks and bonds, is smoothed out so as not to
affect employers’ pension plan expense too much in any particular year.

The climate for introducing market-value accounting into financial statements
did not change until 1990, in the aftermath of the savings and loan crisis and the
consequent US government bail-out of insolvent savings and loan associations, On
10 September 1990, the US Securities and Exchange Commission, in testimony
by its chairman before the US Senate’s Committee on Banking, Housing, and
Urban Affairs, described how faulty accounting and the consequent improper
measurement of regulatory capital contributed to lax regulatory oversight of the
S&Ls, which ultimately led to the bail-out. The commission in that testimony took
the position that banks and thrifts should mark to market their bond portfolios. At
that time, Richard Breeden was chairman of the SEC. Chairman Breeden is a
lawyer, not an accountant. But he strongly believed that thrifts and banks were
presenting false pictures of their financial positions and results of operations, and
importantly the amounts of their regulatory capital, through the use of historical
cost accounting for their bond portfolios and through selective timing of sales of
bonds so as to trigger gains but not losses, a practice called “gains trading.”

When I was interviewed by Chairman Breeden for the position of chief
accountant in December 1991, it turned out that his and my thoughts on market-
value accounting were in sync, At least as far as bond portfolios were concerned.
Chairman Breeden did not want to go further than the bond portfolio. I wanted to
mark all assets to market, but in the early 1990s, I was glad to start with the bond
portfolios of thrifts and banks. So, in January 1992,1 started as chief accountant to
the SEC. As it turns out, I was the commission’s foot soldier getting thrifts and
banks to mark to market their bond portfolios. Of course, there was no stopping
with depository institutions. Insurance companies and other “float” companies also
had bond portfolios, and they also had to mark to market their bonds. I was chief
accountant from January 1992 to April 1995. I spent a considerable portion of 1992
and 1993 promoting the commission’s view that banks, thrifts, and insurance
companies should mark to market their bond portfolios.

In May 1993, the FASB, in Statement 115, required that all marketable equity
securities be marked to market. Statement 115 went part of the way on bonds,
requiring that trading and held-for-sale bond portfolios be marked to market, but it
allows a held-to-maturity bond portfolio to be reported at cost. (Determining which
bond is in which portfolio is a metaphysical, serendipitous determination that has
always eluded my understanding.) Since 1993, the accounting for bonds,
mortgages, mortgage-backed securities, derivative instruments, and hedging has
become more incredibly complex than I can or want to describe, but gains trading
out of the held-to-maturity portfolio is still possible. However, the FASB is moving
forward to require mark-to-market accounting of all financial assets and liabilities.

292 ACCOUNTING STANDARD SETTING AND REGULATION

served as a commissioner since the commission was established in 1934. Most, but
not all, of the commissioners have been lawyers. An exception is Arthur Levitt, the
immediate past chairman, who is not an attorney Chairman Levitt, prior to his
appointment to the SEC, was head of the American Stock Exchange.)

When the SEC endorsed marking to market of bonds in 1990, the banking,
thrift, and insurance companies community had to be dragged, kicking and
screaming, into the world of relevant, mark-to-market accounting. In a sense, the
FASB was also dragged along by the SEC, because none of the FASB’s constituencies
was in favor of mark-to-market accounting, and the FASB itself was not out in front
leading the charge for mark-to-market accounting. But come around it did, and now
the FASB is moving forward on mark-to-market accounting for all financial assets
and liabilities.

I think that it is now time for the SEC, the FASB, and the reconstituted
International Accounting Standards Board to extend mark-to-market accounting to
the rest of the balance sheet—to all assets and liabilities. Why do I say that? Well, to
begin with, there is no question that mark-to-market accounting produces relevant
information that investors and creditors can use to make investment decisions. Not
only is the information relevant, its quality is undisputed. The two ideas—relevance
of information and quality—go hand in glove. There is no relevance to a datum
called cost or cost minus amortization—it is just a number, a number having no
information content. The “quality” of the datum called cost or cost minus
amortization for assets such as inventory, factories, mines, oil and gas reserves,
salmon farms, machinery and equipment, copyrights, and patents is indisputably
awful; worse, it can be and often is misleading. We have seen many situations in the
USA, and I’m sure you have seen them in Australia as well, where corporations have
been reporting earnings and an excess of assets over liabilities using our current
generally accepted accounting principles just before going bust. We now have the case
where after the tragic events of September 11th some US airlines are teetering on
the brink of bankruptcy and the market prices of their aircraft have fallen into the
cellar. Yet the historical cost of those aircraft continues on the airlines’ balance
sheets because, under the FASB’s rule in Statement 121 and now Statement 144 of
looking to the undiscounted future cash flows from the aircraft, the carrying
amount of the aircraft is not impaired. What an awful rule. Historical cost of assets
and representations as assets of FASB-approved junk such as goodwill, deferred
income taxes and tax benefits of operating loss carryforwards, and capitalized direct-
response advertising costs have misled investors for years. I will have more on
quality later.

The second reason to adopt mark-to-market accounting for all assets and
liabilities is to go back to basics—to go back to first principles—and to simplify the
accounting. First, we need a definition of assets that we can all understand. The
FASB’s definition of assets in paragraph 25 of its Concepts Statement 6 is as
follows: “Assets are probable future economic benefits obtained or controlled by a
particular entity as a result of past transactions or events.” That is followed by six
paragraphs of about 600 words explaining the definition. There are 330,000

MARK TO MARKET ACCOUNTING 293

members of the American Institute of Certified Public Accountants. It is my
experience that a very large majority of those CPAs do not understand the FASB’s
definition of an asset. I have seen litigation involving alleged fraudulent financial
statements because of improper asset and income recognition where both parties to
the litigation and both of their expert witnesses, in their briefs and at trial, quoted
the very same words from the FASB’s Concepts Statements saying that a debit
balance on the balance sheet was, or was not, a fit and proper asset under the
FASB’s definition. The judge has not yet decided the case, even though three years
have gone by.

Not only do most practicing accountants not understand the FASB’s language
about assets; ordinary folk are also mystified by that babble. The financial
statements that are produced as a result of all of the FASB’s rules, which is now a
veritable mountain of rules, are impenetrable. Co to the Internet and look at the
financial statements and related notes to the financial statements of US companies
in their annual reports. There are pages and pages of jargon, understandable to a few
highly indoctrinated accountants but not to most investors and other ordinary folk.
This is not just my opinion. The new chairman of the SEC, Mr Harvey Pitt, is
quoted on page 92 in the 5 November 2001 issue of Business Week as saying that
quarterly and annual reports are “not always capable of being deciphered by
sophisticated experts, much less ordinary investors.”

Using the FASB’s definition of an asset, a thing that most of us call a truck is not
that which is the asset. The asset is the economic benefit, whatever that is, that will
arise from using the truck to haul lumber or coal or bread. Using the FASB’s
definition, the truck is an abstraction. I think that we should define assets by
reference to real things, not abstractions. I think that we should define assets as
follows: cash; claims to cash, for example accounts and notes receivable; and things
that can be sold for cash, for example a truck. I’ll bet that this audience understands
my definition of an asset.

The FASB’s definition of a liability in paragraph 35 of Concepts Statement 6 is as
murky as its definition of an asset, to wit: “Liabilities are probable future sacrifices
of economic benefits arising from present obligations of a particular entity to
transfer assets or provide services to other entities in the future as a result of past
transactions or events.” That paragraph is followed by five paragraphs of more than
700 words that explain the definition. Included in those five paragraphs is a
sentence that says liabilities include, in addition to legal obligations, “equitable or
constructive obligations,” but it does not define what those are. Most accountants
do not understand, at the margin, what the FASB’s definition of a liability means,
leading to great diversity in practice. In practice, if the management of a corporation
says that it has a liability under a so-called restructuring plan, a liability may be, but
need not be, booked. In practice, year-end bonuses to employees are sometimes, but
not always, booked as liabilities as the year progresses, even though there is no
contractual obligation to pay the bonuses. We are seeing in 2001 that many US
corporations are not going to pay bonuses or are going to pay reduced amounts of
bonuses. (See the Wall Street Journal, 2 October 2001, p. B1; I doubt that there is

294 ACCOUNTING STANDARD SETTING AND REGULATION

much disclosure in financial statements about those liability reversals.) In corporate
acquisitions, liabilities are booked if the acquiring corporation declares that it will
pay out cash for this or that even though there is no contractual requirement to pay
cash; no liability is booked if the corporation makes no declaration. Consequently,
liability recognition, and the amount thereof, is subject to great management
discretion and abuse.

I think that liabilities should be defined as follows: cash outflows required by
negotiable instruments, by contracts, by law or regulation, and by court-entered
judgments and agreements with claimants. I’ll bet that this audience understands
my definition of liabilities. Nothing murky about it.

The third reason to adopt mark-to-market accounting for all balance sheet items
is to stop—to stop dead in its tracks—earnings management. Earnings management
is a scourge in the USA. The disease called earnings management is endemic. I am
not being shrill or alarmist when I say that I think that it threatens the very soul of
financial reporting. What we get under our present reporting system is earnings as
determined by management, not as determined by transactions and economic
events and conditions that actually happened and exist. Many people, indeed many
accountants, are fond of saying that financial statements should portray economic
reality. But, in fact, except for the financial statements of investment companies
(mutual funds) and broker/dealers, where all assets are marked to market every
evening at the close of business, today’s financial statements come nowhere close to
achieving that goal because, except for stocks, and bonds in some cases, non-cash
assets are not marked to market.

In the spring of 1998, a national business magazine in the USA—Forbes—had
the following banner on its cover: “Pick a Number, Any Number.” That was
followed by articles in the national press, such as USA Today, about “Abracadabra
accounting,” “Hocus-pocus accounting,” and the like. The gist of these articles was
that the accounting numbers were being managed or manipulated by corporations
and certified as being OK by their external auditors. This national outrage moved
Chairman Levitt of the SEC into action. On 28 September 1998, Chairman Levitt
gave a speech entitled “The numbers game” (this speech is available at
www.sec.gov). In that speech, he gave examples of ways in which corporations are
managing their earnings—big bath restructuring charges, creative acquisition
accounting, cookie jar reserves, improper revenue recognition, and abuse of
materiality. (I would point out that under our current accounting rules there are
dozens of ways to manage earnings. Chairman Levitt gave only a few examples.)
Chairman Levitt made numerous suggestions for improvement. The upshot of that
speech was (1) the SEC’s staff produced staff accounting bulletins on restructuring
charges, revenue recognition, materiality, and banks’ loan loss allowances; (2) the
New York Stock Exchange and the NASDAQ charged a blue-ribbon panel chaired
by two prominent business leaders, Ira Millstein and John Whitehead, with making
recommendations about corporate audit committees; and (3) the Public Oversight
Board of the American Institute of Certified Public Accountants charged the Panel
on Audit Effectiveness chaired by Shaun O’Malley, formerly CEO of

MARK TO MARKET ACCOUNTING 295

PricewaterhouseCoopers, with making recommendations about improving the
effectiveness of external audits.

The Millstein—Whitehead Blue Ribbon Committee issued its report on 8
February 1999 (the report is available at www.nyse.com). Among the committee’s
recommendations are that (1) there be a discussion between the audit committee
and the external auditor about the quality of the company’s accounting and (2) that
the audit committee represent in the company’s annual report that, based on
discussion with management and the external auditor, the company’s financial
statements are fairly presented in conformity with generally accepted accounting
principles. The second recommendation attracted massive negative comment from
the corporate and legal communities. Commentators stated that audit committee
members are not accountants and do not have the expertise to determine whether
the company’s financial statements conform to generally accepted accounting
principles. When the SEC adopted its revised rules on audit committees on 22
December 1999 (see SEC Release No. 34.42266 at www.sec.gov). the commission
did not adopt that recommendation. Instead, the SEC merely required that the
audit committee state, in the annual report, that, after discussion with the external
auditor, the audit committee “recommended to the Board of Directors that the
audited financial statements be included in the Annual Report,” thereby implicitly
acknowledging that members of audit committees don’t know whether the financial
statements comply with generally accepted accounting principles.

The recommendation that the audit committee discuss with the external auditor
the quality of the company’s accounting has been acted on by the auditing
profession in the USA. In December 1999, the AICPA’s Auditing Standards Board
issued Statement on Auditing Standards No. 90, Audit Committee Communications,
which requires, as to public companies, that the auditor “discuss with the audit
committee the auditor’s judgments about the quality, not just the acceptability, of
the company’s accounting principles as applied in its financial reporting.” I would
like to be a fly on the wall when such discussions take place in the corporate
boardroom. I can just imagine the auditor saying to his/her client, “My firm has
audited your financial statements. My firm is prepared to report without
qualification that your financial statements have been prepared in conformity with
generally accepted accounting principles, but my grade on the quality of your
financial statements is C–.” In my opinion, this requirement by the Auditing
Standards Board is worse than a joke. It is farcical. The large auditing firms have
hundreds, some thousands, of partners in the USA and still more worldwide. There
are no objective standards by which the individual partner in San Francisco,
Sydney, Seoul, Singapore, or Southampton can make a judgment about the quality
of a client’s accounting. Following the Auditing Standards Board’s rule, opinions
about the quality of clients’ accounting would be based on the idiosyncratic
judgments of hundreds or thousands of individual partners. The practical upshot
will be that every client’s grade on quality will be an A. There are two reasons for
that. First, given the highly competitive nature of the public accounting business,
few if any audit partners are going to jeopardize a client relationship by telling the

296 ACCOUNTING STANDARD SETTING AND REGULATION

client that its accounting is not of high quality. The second reason is that the
accounting rules under which financial statements are prepared allow the
management to use its judgment in preparing those financial statements, and the
auditor has no basis on which to make a different judgment except personal
preference.2

The O’Malley Panel issued its 255-page report on 31 August 2000 (that report may
be viewed at www.pobauditpanel.org). The panel’s major recommendations are as
follows:

• Auditors should perform some “forensic-type” procedures on every audit to
enhance the prospects of detecting material financial statement fraud.

• The Auditing Standards Board should make auditing and quality control
standards more specific and definitive.

• Audit firms should put more emphasis on the performance of high-quality audits
in communications from top management, performance evaluations, training,
and compensation and promotion decisions.

• The Public Oversight Board (POB) of the AICPA, the AICPA, the SEC Practice
Section (SECPS) of the AICPA, and the SEC should agree on a unified system
of governance for the auditing profession under a strengthened Public Oversight
Board that would oversee standard setting (for auditing, independence, and
quality control), monitoring, discipline, and special reviews.

• The SECPS should strengthen the peer review process, including requiring
annual reviews for the largest firms, and the POB should increase its oversight of
those reviews.

• The SECPS should strengthen its disciplinary process.
• Audit committees should pre-approve non-audit services that exceed a threshold

amount.
• The International Fédération of Accountants should establish an international

self-regulatory system for the international auditing profession.

As I understand it, the Auditing Standards Board and other AICPA entities are
working on the panel’s recommendations. And I have no doubt that the SEC’s staff
is watching over their shoulders to make sure that all of the details are implemented
to the SEC staff’s satisfaction. Maybe the number of financial statement frauds that
the SEC periodically has to investigate and address through enforcement actions
will be reduced if more “forensic-type” audit work is done by external auditors as
recommended by the panel. But the earnings management game won’t stop even if
every one of the panel’s recommendations is implemented immediately. And the
dismaying, surprise corporate collapses-such as HIH Insurance here in Australia—
that happen about once a month won’t stop even if every one of the panel’s
recommendations is implemented immediately.

There have been similar panels, committees, and even Royal Commissions in the
past, all with more or less similar recommendations. We now have O’Malley. We
had the Kirk Panel in the 1990s. We had Treadway about fifteen years ago. We had

MARK TO MARKET ACCOUNTING 297

the Cohen Commission in the late 1970s. We had Metcalf. Canada had
MacDonald. Great Britain had Cadbury. Australia has had similar committees, I’m
sure. In the 1970s, we in the USA introduced peer reviews of audit firms.
Concurring audit partner reviews are also now a requirement in the USA. We have
the AICPA’s Quality Control Inquiry Committee looking into external auditor
performance when financial statements are restated. We have the AICPA’s Public
Oversight Board breathing hard, looking over everyone’s shoulder. All for nought.
What we have is layers on top of layers on top of layers of regulation. After
O’Malley, we no doubt will have another layer of regulation.

We had the AICPA’s Committee on Accounting Procedure writing the
accounting rules from 1939 to 1959. That didn’t work, and that committee was
replaced by the AICPA’s Accounting Principles Board, which wrote the accounting
rules until 1973. In 1973, the Accounting Principles Board was replaced, with great
hope and fanfare, by the Financial Accounting Standards Board.3 Things were
supposed to get better. But nothing has changed. Earnings management continues
to flower.

Corporations today continue to manipulate their earnings without objection from
their external auditors. SEC Commissioner Hunt, in a speech on 26 October 2001,
discussed earnings management (see www.sec.gov). Business Week, on page 71 of its
23 July 2001 issue, reported that “In today’s financial climate, auditors’ reports have
about as much credibility as buy recommendations from Wall Street analysts.” The
June 2001 issue of the Harvard Business Review has a twelve-page article entitled
“The Earnings Game: Everyone Plays, Nobody Wins.” On 19 October 2001, on a
Friday night TV program called Wall Street Week, I heard and saw a prominent
Wall Street investment manager say something along the following lines:
“Corporations are writing off assets right and left in the quarter ended September 30
2001. Comparative earnings statements in 2002 will be wonderful.” His implication
was that the write-downs are arbitrary. The Levy Institute Forecasting Center, in a
special research report dated September 2001, describes in twenty-three pages of
detail “two decades of overstated corporate earnings,” which its chairman, David
Levy, previewed on TV on CNBC on 24 October 2001. Business Week, on pages 46
and 47 of its 15 October 2001 issue, reported:

Brace yourself for what may be the ugliest quarter ever for corporate earnings.
For years, companies used every trick in the book to make their results look
better than they really were. Now, many will be taking the opposite tack:
loading costs and charges onto their income statements in an all-out effort to
make an already horrid year look even worse. To make next year’s results look
stronger companies may load losses into 2001 by slashing values of physical
assets, which will cut depreciation charges in the future; overestimating likely
bad debts, thus boosting future profits when customers pay up; and charging
impending restructuring costs immediately, so as to benefit if they’re less than
expected.

298 ACCOUNTING STANDARD SETTING AND REGULATION

It’s not just in Business Week and the Harvard Business Review. I see it in Forbes. I see
it in Barron’s. I read the earnings reports of corporations on their websites and in the
Wall Street Journal, and I see the earnings management. It is going on in bright
daylight and not behind closed doors. Everyone on Wall Street knows it is going
on. The stock exchanges know it is going on. The SEC knows it is going on. Every
sell-side security analyst knows it is going on. Every institutional investor knows it is
going on. But the individual investor who is not part of the Wall Street in-the-know
crowd doesn’t know it is going on. John and Jane Q. Public don’t know it is going
on. Maybe members of Congress don’t know it is going on. The external auditors
can’t stop it. Even if the external auditors were US federal government auditors,
whose independence would be unquestionably pure, they could not stop it, because
the accounting rules allow for earnings management. External auditors have no
ground on which to stand to stop it because of the way the accounting rules are
constructed. The stock exchanges can’t stop it. Because the accounting rules allow
for earnings management, the SEC can’t stop it through its Division of Corporation
Finance, which reviews and clears registration statements and other filings by issuers
of securities. The SEC’s Office of the Chief Accountant and Division of
Enforcement can’t stop it, because the accounting rules allow it. I could not stop it
when I was chief accountant at the SEC.

I have been in this business since 1 August 1957. I think that I have seen every
side and dimension of this problem. In my opinion, the only way that earnings
management will be stopped is as follows: the SEC, or the SEC and the FASB, or the
SEC and the FASB and the IASB, must change the accounting rules. The SEC
must make deep and fundamental changes to the system. Unless and until the SEC
requires that assets be reported at estimated selling prices, which of course means
that only things that have a market price could be represented as assets, nothing will
change. Unless and until the SEC requires that liabilities be reported at estimated
settlement prices, nothing will change. Unless and until the SEC requires that
reported asset and liability amounts be based on estimated selling and settlement
prices and that external auditors get evidence about those selling and settlement
prices from persons or entities outside the reporting enterprise, nothing will change.

So long as management controls the numbers, nothing will change. For example,
so long as management decides on the amount of inventory obsolescence, the
amount of bad debts, or the amount of the warranty liability, nothing will change.
So long as management decides on the assumed rate of return on pension plan
assets, nothing will change. So long as management decides on the estimated useful
lives and salvage values of capital assets without regard to the selling prices of those
assets as determined by the marketplace, nothing will change. So long as
management decides on what will be future undiscounted cash flows from capital
assets, and can change those numbers at will in determining whether the carrying
amounts of capital assets are impaired, nothing will change. So long as management
is allowed to recognize liabilities for restruc turing the business whenever it wants
to, and in an amount determined solely by management, nothing will change.

MARK TO MARKET ACCOUNTING 299

The reported numbers for assets and liabilities must be such that they can be
verified by external auditors (and by regulators and courts) by reference to sources
outside the enterprise. By reference to competent evidence.4 The SEC must make
deep and fundamental change to the system. Only by requiring that assets and
liabilities have a reference point in the marketplace and that the amounts
representing those assets and liabilities be verifiable by reference to sources,
competent sources,5 outside the enterprise will we be able to produce financial
statements that include reliable numbers. As a practical matter, neither the FASB nor
the IASB can accomplish such deep and fundamental change on its own. Or even
together. Only the SEC can accomplish such change. And only if such change is
made will the financial statements be of high quality.

This idea that financial statements be of high quality, or that accounting standards
be of high quality, has attracted a lot of attention recently. The term “high quality”
is on everyone’s lips. It is high-sounding. The IASB’s website says that the IASB “is
committed to developing, in the public interest, a single set of high-quality,
understandable, and enforceable accounting standards that require transparent and
comparable information in general purpose financial statements.” The US House of
Representatives’ Subcommittee on Capital Markets, Insurance, and Government
Sponsored Enterprises, on 7 June 2001, held a hearing on “Promotion of
International Capital Flows through Accounting Standards.” Representatives Baker,
Oxley, LaFalce, Kanjorski, and Mascara made “opening statements.” Paul Volcker,
chairman of the trustees of the IASB, Philip Ameen, VP and comptroller of General
Electric, representing Financial Executives International, and Robert Elliott, a
KPMG partner representing the AICPA, testified before the subcommittee about
international accounting standards. By my count, the US representatives, Mr
Volcker, Mr Ameen, and Mr Elliott, in their prepared remarks, used the term “high
quality” no fewer than twenty-three times. Sometimes high-quality standards,
sometimes high-quality financial statements, and sometimes high-quality
information. Mr Lynn Turner, the SEC’s chief accountant from mid-1988 to
mid-2001, used the term frequently in his speeches when describing financial
statements prepared under FASB standards and when he described what he hopes
will result under IASB standards. But I can’t tell what it is that these people are
describing. These people are obviously not describing what Chairman Levitt
described in his September 1998 speech, what Commissioner Hunt described in his
speech on 26 October 2001, and what Chairman Pitt meant when he said that
quarterly and annual reports are indecipherable by ordinary investors. These people
are obviously not describing what I see in the Harvard Business Review, Business
Week, Forbes, and Barron’s about earnings management. To me, these people sound
like my seven-year-old granddaughter, who is wishing that Santa Claus will bring
her a pony on Christmas morning.

What is it that we want for investors when we say “high-quality financial
statements” or “high-quality information?” I’ll tell you what I want. I want financial
statement amounts (numbers) that are relevant and reliable. Historical costs of assets
and historical proceeds of liabilities are not relevant to an investor for the purpose of

300 ACCOUNTING STANDARD SETTING AND REGULATION

making an investment decision—or to any business person wanting to make a
decision about an asset or a liability. Only current selling prices for assets and
current settlement prices for liabilities are relevant. The only reliable measures of
these prices are those that come from the marketplace, from persons or entities
unrelated to the reporting enterprise. Selling prices of assets and settlement prices of
liabilities can be verified by external auditors by reference to marketplace sources. If
the SEC requires that assets and liabilities be measured, and be verified by external
auditors, by reference to selling and settlement prices that exist in the marketplace,
and requires disclosure of the names of persons or entities that furnished those
prices, the resulting financial statements will be of high quality. And that standard,
unlike what we have today, will be enforceable by external auditors, regulators, and
ultimately the courts.

There is a new chairman, Harvey Pitt, and a new chief accountant, Robert
Herdman, at the SEC. Mr Pitt made a speech on 22 October 2001 (see
www.sec.gov) before the governing council of the AICPA in which he spoke of
“simplifying financial disclosures to make accounting statements useful to, and
utilizable by, ordinary investors” and that “we [the SEC] may need to reconsider
whether our accounting principles provide a realistic picture of corporate
performance.” The SEC’s press release on 19 September 2001 (see www.sec.gov)
announcing Mr Herdman’s appointment as chief accountant says, “Mr. Herdman
will lead us [the SEC] in revising and modernizing our accounting and financial
disclosure system.” Those words are promising. Maybe Mr Pitt and Mr Herdman will
surprise investors with the equivalent of a pony on Christmas morning—that is,
high-quality financial statements.

Postscript: 9 December 2001

After I presented this lecture, I received in the mail a brochure advertising a two-day
course entitled “How to Manage Earnings in Conformance with GAAP.” “This
Intensive Two-day, Skill-based Workshop Features over 50 Illustrations,
Applications and Case Studies to Make GAAP Work for Your Company or Client.”
“Earn 16 Hours of A&A CPE Credit and CLE Credit.” This course is sponsored by
the National Center for Continuing Education, 967 Briarcliff Drive, Tallahassee,
FL 32308, and it costs $995. I rest my case about earnings management being a
disease.

Notes

1 FASB Statement 12, issued in 1975 and now superseded by Statement 115, required
lower of cost or market accounting for the portfolio of marketable equity securities
held, which is awful accounting. In Statement 12, I wanted to require mark-to-market
accounting for every security in the portfolio, as did two other board members, Messrs
Litke and Sprouse, who dissented to the issuance of Statement 12. But because we
needed five votes to issue a standard, and because our constituents were telling us that

MARK TO MARKET ACCOUNTING 301

practice was so diverse that a standard, some standard, was necessary, I bit my tongue
and signed the document without dissenting.

2 For an excellent discussion and analysis of why the presence of audit committees
cannot and will not improve the quality and reliability of today’s financial statements,
see “Are audit committees red herrings?” by P.W.Wolnizer, Abacus, Vol. 31, No. 1,
March 1995, pp. 45–66.

3 I know. I was a charter member of the FASB. My wife and I were present at the
FASB’s inauguration dinner in the spring of 1973. Reginald Jones, chairman of
General Electric, delivered the inaugural address. He held out great hope for the FASB.

4 This style of auditing—obtaining competent evidence—is exactly what P.W.Wolnizer
describes and recommends in his book Auditing as Independent Authentication, Sydney
University Press, 1987.

5 The SEC should require (1) disclosure, either by the reporting enterprise or the
external auditor, of the names of the persons or entities that furnished the selling and
settlement prices and (2) the consent of those persons or entities to the use and
disclosure of their names.

302 ACCOUNTING STANDARD SETTING AND REGULATION

45
Hearing

“Accounting and Investor Protection Issues Raised by Enron
and Other Public Companies: Oversight of the Accounting

Profession, Audit Quality and Independence, and
Formulation of Accounting Principles”

Prepared statement by Mr Walter P.Schuetze, chief accountant,

Securities and Exchange Commission 1992–5, before the US Senate

Committee on Banking, Housing, and Urban Affairs, 26 February

2002

Thank you, Mr Chairman. Senator Gramm. Members of the Committee. My name
is Walter P.Schuetze. My brief resumé is attached hereto.

Just a few comments about my experience and background. I was on the staff and
a partner with the public accounting firm KPMG and its predecessor firms for more
than thirty years. I was one of the charter members of the Financial Accounting
Standards Board from April 1973 through June 1976. I was a member and chair of
the Accounting Standards Executive Committee of the American Institute of
Certified Public Accountants in the 1980s. I was chief accountant to the Securities
and Exchange Commission from January 1992 through March 1995 and chief
accountant of the SEC’s Division of Enforcement from November 1997 through
mid-February 2000.

I need to mention that although I am retired, I am a consultant to the Securities
and Exchange Commission and several other entities under consulting contracts. In
addition, I have one remaining tie with my former firm KPMG in that I am insured
under a group life insurance contract obtained and administered by that firm; I pay
the premium attributable to me. The views I express here today are my personal
views.

I appreciate very much the opportunity to testify here today. Your letter of 16
January 2002 inviting me to testify at this hearing says:

A number of high-profile business failures in recent years, including, most
recently, the collapse of Enron Corp., have involved significant accounting
irregularities, and the February 26 hearing will examine the issues raised by
those failures for financial reporting by public companies, accounting stan-
dards, and oversight of the accounting profession. You should feel free to
address those issues as you see fit. The committee would also appreciate any
recommendations you may have about ways to deal with the issues you
discuss.

I indeed have a major recommendation, which I will get to at the conclusion of my
remarks.

The public’s confidence in financial reports of and by corporate America, and in
the audits of those financial reports by the public accounting profession, has been
shaken badly by the recent surprise collapse of Enron, by recent restatements of
financial statements by the likes of Enron, Waste Management, Sunbeam, Cendant,
Livent, and MicroStrategy, and by the SEC’s assertion of fraud by Arthur Andersen
in connection with its audits of Waste Management’s financial statements in the
1990s, which Andersen did not admit or deny in a settled SEC action last summer.
The public’s confidence needs to be regained and restored. If that confidence is not
regained and restored, the result will be that investors will bid down the price of
stocks and bonds issued by both US and foreign corporations; we have seen
evidence of that phenomenon in recent weeks. That is an investor’s natural response
to increased risk or the perception of increased risk. This will reduce the market
capitalization of corporations, which in turn will negatively affect capital formation,
job creation and job maintenance, and ultimately our standard of living. So, we are
concerned today with a very important matter.

You will hear or have heard many suggestions for improvement to our system of
financial reporting and audits of those financial reports. Some will say that auditor
independence rules need to be strengthened. That external auditors should not be
allowed to do consulting work and other non-audit work for their audit clients. That
external audit firms should be rotated every five years or so. That external auditors
should be prohibited from taking executive positions with their corporate clients for
a number of years after they have been associated with the audit firm doing the
audit unless the firm resigns as auditor. That peer reviews of auditors’ work need to
be improved and done more frequently if not continuously. That auditors should be
engaged by the stock exchanges and paid from fees paid to the exchanges by listed
companies. That the oversight of auditors needs to be strengthened. That
punishment of wayward auditors needs to be more certain and swift. In that regard,
Chairman Pitt of the SEC has proposed that there be a new Public Accountability
Board overseeing the external audit function; this board would, as I understand it,
have investigative and disciplinary powers. And so on and on. In my opinion, those
suggestions, even if legislated by Congress and signed by the President, will not fix
the underlying problem.

The underlying problem is a technical accounting problem. The problem is
rooted in our rules for financial reporting. Those financial reporting rules need deep
and fundamental reform. Unless we change those rules, nothing will change. The
problems will persist. Today’s crisis as portrayed by the surprise collapse of Enron is
the same kind of crisis that arose in the 1970s when Penn Central surprisingly
collapsed and in the 1980s when hundreds of savings and loan associations
collapsed, which precipitated the S&L bail-out by the federal government. Similar
crises have arisen in Australia, Canada, Great Britain, and South Africa. There will
be more of these crises unless the underlying rules are changed.

304 ACCOUNTING STANDARD SETTING AND REGULATION

Under our current financial reporting rules promulgated by the Financial
Accounting Standards Board, management of the reporting corporation controls
and determines the amounts reported in the financial statements for most assets.
For example, if management concludes, based on its own subjective estimates, that
the cost of an asset—say equipment—will be recovered from future cash flows from
operations without regard to the time value of money or risk, no write-down is
required even when it is known that the current market price of the asset is less than
the cost of the asset. The external auditor cannot require that the reported amount
of an asset be written down to its estimated selling price; the external auditor cannot
even require the corporation to determine the estimated selling price of the asset and
disclose that price in its financial statements. So when it comes time to sell assets to
pay debts, there are often surprise losses that investors then see for the first time.
Management also makes similar assessments in determining the amount of
inventory obsolescence, the allowance for bad debts, and whether declines in the
values of investments below cost are “other than temporary.”

Under our current accounting rules, corporate management often records sales
and trade receivables at 100 cents on the dollar even though a bank or a factor
would pay only pennies on the dollar for those trade receivables. We have seen that
phenomenon in the past few years in the telecom rage, where sales and receivables were
recorded, followed several months later by write-offs of the receivables. On another
front, we are currently seeing swaps of assets and the recognition of gains in what is
effectively a barter transaction, even though the fair value of what was exchanged is
apparently negligible.

Except for inventories and marketable securities, none of these asset amounts in
the financial statements—trade receivables, commercial and consumer loans
receivable, real estate loans, oil and gas reserves, mineral deposits, pipelines, plant,
equipment, investments—is subjected to the test of what the cash market price of
the asset is. Yet we know that most individual investors and, in my experience, even
many sophisticated institutional investors believe that the reported amounts of
assets in corporate balance sheets represent the current market prices of those assets;
nothing could be further from the truth.

And under the FASB’s definition of an asset, corporations report as assets things
that have no market price whatsoever; examples are goodwill, direct-response
advertising costs, deferred income taxes, future tax benefits of operating loss
carryforwards, costs of raising debt capital, and interest costs for debt said to relate
to acquisition of fixed assets. I call these non-real assets. Today’s corporate balance
sheets are laden with these non-real assets; this is the kind of stuff that allows stock
prices to soar when in fact the corporate balance sheet is bloated with hot air. Of
course, when it comes time to pay bills or make contributions to employees’ pension
plans, this stuff is worthless.

The same goes for liabilities. Corporate management determines the reported
amount of liabilities for such things as warranties, guarantees, commitments,
environmental remediation, and restructurings. Again, this is as per the FASB’s
accounting rules.

MARK TO MARKET ACCOUNTING 305

The upshot is that earnings management abounds. Earnings management is like
dirt; it is everywhere. SEC commissioners have made speeches decrying earnings
management. Business Week, Forbes, Barron’s, the New York Times, the Wall Street
Journal, and the Harvard Business Review carry hand-wringing articles about earnings
management. Earnings management is talked about matter-of-factly on Wall Street
Week and Bloomberg TV, on CNBC, CNNfn, and MSNBC. Earnings management
is a scourge in this country. Earnings management is common in other countries as
well because their accounting rules, and the accounting rules promulgated by the
International Accounting Standards Board, are much the same as ours.

We need to put a stop to earnings management. But until we take control of the
reported numbers out of the hands of corporate management, we will not stop
earnings management and there will be more Enrons, Waste Managements, Livents,
Cendants, MicroStrategies, and Sunbeams. How do we take control of the reported
numbers out of the hands of corporate management? We do it by requiring that the
reported numbers for assets and liabilities, including guarantees and commitments,
be based on estimated current market prices—current cash selling prices for assets
and current cash settlement prices for liabilities. And by requiring that those prices
come from, or be corroborated by, competent, qualified, expert persons or entities
that are not affiliated with, and do not have economic ties to, the reporting
corporate entity. And by requiring that the names of the persons or entities
furnishing those prices, and the consents to use their names, be included in the
annual reports and quarterly reports of the reporting corporate entity so that investors
can see who furnished the prices.

Let me give you an example of what I am talking about. Pre-September 11,
2001, the major airlines, to the extent that they own aircraft instead of leasing
them, had on their balance sheets aircraft at the cost of acquiring those aircraft from
Airbus and Boeing. Let’s say that cost was $100 million per aircraft. The market
prices of those aircraft fell into the basement post-September 11 to about $50
million per aircraft and remain there today, although prices have recovered
somewhat. Yet, under the FASB’s rules, those airlines continue to report those
aircraft on their balance sheets at $100 million and are not even required to disclose
that the aircraft are worth only $50 million. Under mark-to-market accounting the
aircraft would be reported at $50 million on the airlines’ balance sheets, not $100
million.

I could give you many more examples, but I will add just one more. In the late
1970s, this country was experiencing great inflation. The Federal Reserve Board
raised short-term interest rates dramatically. Long-term rates shot up. As a
consequence, the market value of previously acquired residential mortgage loans and
government bonds held by savings and loan associations declined drastically. But
the regulations of the Federal Home Loan Bank Board and the FASB’s accounting
rules said that it was OK for the mortgage loans and bonds to be reported at their
historical cost. Consequently, the S&Ls appeared solvent but really were not. This
mirage allowed the S&Ls to keep their doors open and in so doing they incurred
huge operating losses because their cost of funds far exceeded their interest income

306 ACCOUNTING STANDARD SETTING AND REGULATION

on loans and bonds in their portfolios. Some of the S&Ls decided to double down
by investing in risky real estate projects, also accounted for at historical cost, and
proceeded to lose still greater amounts, which losses were also hidden on the balance
sheet under the historical cost label. The Federal Home Loan Bank Board even
went so far as to allow S&Ls to capitalize and report as assets losses on sales of
assets, but the FASB said no to that procedure. Of course, when the federal
government had to bail out the insolvent S&Ls in the 1980s, the federal government
paid for the losses that were hidden in the balance sheet under the historical cost
label and the operating losses that had been incurred while the S&Ls kept their
doors open because of faulty accounting. Had mark-to-market accounting been in
place and had the Federal Home Loan Bank Board computed regulatory capital
based on the market value of the S&Ls’ mortgage loans, government bonds, and
real estate projects, the S&L hole would not have gotten nearly as deep as it
ultimately did.

Various members of Congress have said in recent hearings about Enron that a
corporation’s balance sheet must present the corporation’s true economic financial
condition. A corporation’s true economic financial condition cannot be seen when
assets are reported at their historical cost amounts. The only objective way that the
true economic financial condition of a corporation can be portrayed is to mark to
market all of the corporation’s assets and liabilities. Recall my earlier example about
the cost of aircraft being $100 million and the current market value being $50
million. Mr Chairman and members of the committee: is there any question that
the $50 million presents the true economic financial condition and the $100 million
does not? Moreover, following today’s FASB’s accounting rules produces financial
statements that are understandable only to the very few accountants who have
memorized the FASB’s mountain of rules. “Indecipherable” is the word Chairman
Pitt has used in recent speeches. On the other hand, marking to market will
produce financial statements that investors, members of Congress, and my sister,
who also happens to be an investor, can understand,

The various proposals that have been made to cure Enronitis will not cure the
problem. I liken our current accounting system to bridges built from timber, which
bridges keep collapsing under the weight of eighteen-wheelers. The public demands
that expert consulting engineers be called in to oversee the building of replacement
bridges. But the replacement timber bridges keep collapsing under the weight of
eighteen-wheelers. More expert consulting engineers will not make the timber
bridges any stronger. What needs to be done to fix the problem is build bridges with
concrete and steel. The same goes with accounting. In the 1970s, after the surprise
collapse of Penn Central, the auditing profession insti-tuted peer reviews, where one
auditing firm reviews the work and quality controls of another auditing firm. In the
1970s, auditing firms also instituted concurring partner reviews, where a second audit
partner within the public accounting firm looks over the shoulder of the engagement
audit partner responsible for the audit. These procedures have been ineffectual, as
shown by the dozens of Enrons, Waste Managements, Sunbeams, MicroStrategies,
Cendants, and Livents that have occurred since then. Coincidentally, the Financial

MARK TO MARKET ACCOUNTING 307

Accounting Standards Board also came on the scene in the 1970s; it was going to
write accounting standards that would bring forth financial statements based on
concepts. What happened was that the FASB wrote a mountain of rules that
produce financial statements that nobody understands and that can be and are
gamed by corporate management. What all of that amounted to was continuing to
build timber bridges that keep collapsing under the weight of eighteen-wheelers. We
need to stop building timber bridges. We need to build concrete and steel bridges.
We need to mark to market all assets and liabilities.

Now, you may ask, how much will concrete and steel bridges cost? Can we afford
to build concrete and steel bridges? My response is that we cannot afford not to
build concrete and steel bridges. How much of the cost of the S&L bailout was
attributable to faulty accounting; the amount is unknowable but no doubt was huge.
How much does an Enron or Cendant or Waste Management or MicroStrategy or
Sunbeam cost? The answer for investors is billions, and that does not count the human
anguish when working employees lose their jobs, their 401-k assets, and their
medical insurance, and retired employees lose their cash retirement benefits and
medical insurance. By some estimates, Enron alone cost $60–70 billion in terms of
market capitalization that disappeared in just a few months. Waste Management,
Sunbeam, Cendant, Livent, MicroStrategy, and the others also cost billions in terms
of market capitalization that disappeared when their earnings management games
were exposed. And these costs do not include the immeasurable cost of lost
confidence by investors in financial reports and the consequent negative effect on
the cost of capital and market efficiency.

By my estimate, annual external audit fees in the United States for our 16,000
public companies, 7,000 mutual funds, and 7,000 broker/dealers total about $12
billion. Let’s say that $4 billion is attributable to mutual funds and broker/ dealers.
(Incidentally, mutual funds and broker/dealers already mark to market their assets
every day at the close of business, and we have very few problems with fraudulent
financial statements being issued by those entities. Mark-to-market accounting
works and is effective.) That leaves $8 billion attributable to the 16,000 public
companies. Assume that the $8 billion would be doubled or even tripled if the 16,
000 public companies had to get competent, outside valuation experts (and not the
public accountants, because they are not competent valuation experts) to determine
the estimated cash market prices of their assets and liabilities. We are then looking
at an additional annual cost of $16–24 billion. If we prevented just one Enron per
year by requiring mark-to-market accounting, we would easily pay for that
additional cost. And, when considered in relation to the total market capitalization
of the US corporate stock and bond markets of more than $20 trillion, $16–24
billion is indeed a small price to pay.

The question arises: who should mandate mark-to-market accounting? I
recommend that there be a sense of the Congress resolution that corporate balance
sheets must present the reporting corporation’s true economic financial condition
through mark-to-market accounting for the corporation’s assets and liabilities. I
recommend that Congress leave implementation to the SEC, much the way it is

308 ACCOUNTING STANDARD SETTING AND REGULATION

done today by the SEC for broker/dealers and mutual funds. There will be many
implementation issues, so the SEC will need more staff and money.

My testimony today is a summary of a lengthy article that I wrote about the
definitions of assets and liabilities, earnings management, and mark-to-market
accounting that was published last year in Abacus, a University of Sydney
publication, and that was the basis for the R.J.Chambers Research Lecture that I
presented last year at the University of Sydney. That article and lecture are attached
hereto.

I will be pleased to answer the committee’s questions.

MARK TO MARKET ACCOUNTING 309

46
Watching a game of three-card monte on

Times Square
Remarks to the Southwest Regional Meeting of the American

Accounting Association, Houston, Texas, 7 March 2003

When Sandy Welch asked me in July of last year to speak here today, the Sarbanes-
Oxley Act was being debated and shaped by Congress. President Bush signed that
bill on 30 July 2002. I thought then, and I continue to believe, that Sarbanes-Oxley
would not touch the real problem underlying the malaise that I call “Enronitis.”
The problem is a technical accounting problem, which I will describe.

Let me set the stage for my belief. I think that financial reports about assets and
liabilities, and changes in assets and liabilities, should be based on current market
prices. That is, current, immediate, cash selling prices of assets and current,
immediate, cash settlement prices of liabilities. I assert, and I think it is a truism,
that historical costs of assets and historical proceeds of liabilities, which is what
financial reports are largely based on today, are always irrelevant and often
misleading. In contrast, current, immediate, cash selling prices of assets and current,
immediate, cash settlement prices of liabilities are never misleading and always
relevant.

Consumers here in the USA, and around the world as well, are used to the
“serviceability” of the things that they buy and use every day. By “serviceability,” I
mean that something is “fit for its intended use.”1 For example, we buy Hershey’s
candies and Kellogg’s corn flakes and know that they are fit to eat. We fly around
the world in Boeing and Airbus airplanes and know that the planes are safe. We buy
IBM and Dell desktop and laptop computers that run on Microsoft software and
are delighted with their performance. Caterpillar tractors that we take to
construction job sites, John Deere combines that we take into the wheat fields, and
Honda automobiles that we drive home from the showroom perform flawlessly. We
buy a GE toaster at the department store, knowing that the toaster will not give us a
shock when we plug it into the electricity socket at home. We know that these
products are “fit for their intended use.” Not so for financial reports.

Witness that most retail investors, through no fault of their own, do not
understand the financial reports. Nor in my experience do many institutional

investors. Nor do the men and women in Congress, which became obvious during
the congressional hearings about Enron and WorldCom last year. The reports are
incomprehensible. But, beyond lack of understandability, financial reports as we
know them today affirmatively mislead investors, who are the consumers of those
reports. Those reports are not “fit for their intended use.” Witness the surprise,
elephant-size write-offs of accounts receivable, loans receivable, inventory, fixed
assets, and goodwill, which are often followed by huge declines in the market prices
of the securities of the reporting enterprises. Just last week, Royal Ahold, the Dutch
grocer, disclosed accounting irregularities, and the stock lost almost 70 percent of its
value in two days. Witness the surprise retrospective restatements of previously
issued financial reports to correct errors and irregularities in those reports. Witness
the recent surprise corporate collapses of Enron in 2001 and WorldCom in 2002 to
mention only a few surprise collapses, where prior to the collapse the financial
reports submitted to investors showed that those corporations’ financial health
appeared to be OK. All of this in the presence of unqualified certifications by
outside auditors!

These recent surprises are just that—recent. But since I entered the practice of
public accountancy in 1957, there have been hundreds, maybe thousands, of
surprise corporate collapses and surprise retrospective restatements of financial
statements, where prior to the collapse or the restatement the financial reports
submitted to investors were just like those of Enron and WorldCom—they looked
OK.2 And investors relied on those reports. These financial reports looked OK, but
only superficially so, because the numbers shown for assets were generally based on
historical cost of assets and management’s judgment as to whether those costs were
recoverable through future operations, and the numbers shown for liabilities were
generally the historical proceeds—all of which is as per the encyclo pedia of
Byzantine accounting rules issued by standard setters and regulators in various
countries. That encyclopedia of Byzantine accounting rules did not forestall those
collapses; nor did the unqualified audit reports.

Huron Consulting Group (see note 2) found 330 restatements in 2002.
Assuming 15,000 public company registrants, that is a failure rate of about 2 percent.
Some have defended the current state of affairs, saying that a failure rate of 2
percent is acceptable. Suppose Airbus and Boeing had a failure rate of 2 percent, or
1 percent, or 0.5 percent, or even 0.1 percent. Would any of us fly in their
airplanes? No! Suppose Hershey or Kellogg had that kind of a failure rate? Would
any of us eat the candy or the cereal? No! Enough said.

And now we have the mother of all securities laws, the Sarbanes-Oxley Act of
2002 and SEC-required certification by CEOs and CFOs that the financial
statements of their corporate employer are OK. Or, more precisely, Section 302(a)
of Sarbanes-Oxley requires that the SEC require by rule that the principal executive
officer(s) and the principal financial officer(s) certify in each annual or quarterly
report that:

1 the signing officer has reviewed the report;

ACCOUNTING STANDARD SETTING AND REGULATION 311

2 based on the officer’s knowledge, the report does not contain any untrue
statement of a material fact or omit to state a material fact necessary in order to
make the statements made, in light of the circumstances under which such
statements were made, not misleading;

3 based on such officer’s knowledge, the financial statements, and other financial
information included in the report, present fairly the financial condition and
results of operations of the issuer as of, and for, the periods presented in the
report;

Let’s look at three of those requirements. The first is that the report does not
contain any untrue statement of a material fact. I think that requirement should cause
lots of heartburn. For example, paragraph 13 of FASB Statement 107, Disclosure
about Fair Values of Financial Instruments, requires disclosure of the fair value of
trade receivables if the fair value does not approximate the carrying amount of the
receivables. That requirement is often observed in the breach in today’s financial
reports, and I doubt that most CEOs and many CFOs know of that requirement.
For example, Vice-President Dick Cheney, when he was the CEO of Halliburton,
must not have known about it, because Halliburton booked receivables from clients
for construction cost overruns but did not disclose that practice or that the
receivables, some of which I understand to this day remain uncollected, did not
have a fair value equal to carrying amount. And, as we saw from the disclosures last
week about Royal Ahold’s booking questionable receivables for promotional
allowances, Royal Ahold’s CEO must not have known about that requirement. Not
only is that omitted disclosure a violation of generally accepted accounting principles,
but now, in my opinion, it is also a violation of Sarbanes-Oxley. However, whether
that will be seen as a violation of Sarbanes-Oxley will depend on interpretation by
the courts, and that will take years to develop. So that piece of Sarbanes-Oxley will
not be effective or will take years to be effective.

By way of further example, paragraph 7 of FASB Statement 142, Accounting for
the Impairment or Disposal of Long-Lived Assets, requires that the carrying amount of
long-lived assets (read, property, plant, and equipment) not exceed fair value of the
asset if the carrying amount is not recoverable from future, undiscounted cash flows
resulting from use and eventual disposal of the asset; any excess is recognized as an
impairment loss. Well, guess what. The estimate of future cash flows from the asset
is determined by the management of the enterprise, and FASB Statement 142 does
not require that the estimate be grounded in economic reality or be based on
estimates available in the marketplace. The best current example of impairment
losses that are being carried in the balance sheet under the label of historical cost is
commercial aircraft that are owned by US airlines. Lessors of commercial aircraft are
also carrying losses in their balance sheets instead of reporting them as losses in
income. Those losses were evident before September 11, 2001, because even before
9/11 airplanes were parked in the Arizona and California deserts, and airplane
brokers and owners knew full well about the dismal market conditions for
commercial aircraft. Post 9/11, the desert parking lots are overflowing, but still the

312 MARK TO MARKET ACCOUNTING

losses have not been recognized by the owners of the airplanes, and the dismal
market conditions for commercial aircraft have turned even worse. See, for example,
page 79 of the 20 January 2003 edition of Fortune, which suggests that the losses for
aircraft lessors are in the range of $20 billion. Another example is the current state
of the telecoms. There is huge overcapacity in that industry, but I am aware of no
impairment losses that have been recognized; it is as if no one wants to go near the
issue. I doubt that courts are going to agree that non-recognition of those losses, or
even the lack of disclosure about them, was not material just because of the way a
nonsense accounting rule is written and interpreted by FASB accountants. But
waiting for the courts to interpret those words in Sarbanes-Oxley will take years, so
Sarbanes-Oxley will be years away in fixing this problem, if it ever does.

Now let’s look at omissions to disclose material facts. There are many, many
situations where the fair value of on- and off-book assets is materially different from
book value. I think that whenever the known fair value of an asset is materially
different from the reported carrying amount of that asset, and that would include
unrecognized assets, that is a material fact that requires disclosure under Sarbanes-
Oxley For example, the value of unrecognized mineral deposits and patents is huge
for some companies. But that this is a required disclosure is only my interpretation.
I have talked with several lawyers and accountants about this provision of Sarbanes-
Oxley, and they generally do not agree with me. It seems that lawyers and
accountants are so set in their ways that they do not even want to think about and
talk about meaningful disclosure that will help investors to understand the current
state of affairs of reporting companies. So I don’t see this Sarbanes—Oxley
requirement bearing fruit.

The third requirement is that the financial statements, and other financial
information included in the report, “present fairly” the financial condition and
results of operations of the issuer. Those are high-sounding words. But nobody
knows what they mean. The words are not qualified by reference to generally
accepted accounting principles, deliberately so as I understand it from persons close
to the drafting of the statute. Those words suggest that the term “present fairly”
stands alone without regard to the technical accounting term “generally accepted
accounting principles,” which we find in every set of financial statements, generally
in footnote 1, and in every audit report and in regulation S-X. Do those words,
“presents fairly,” mean something like “true and fair view.” which are words used in
Great Britain and Australia? Well, the people in Great Britain and Australia
obviously don’t know what those words mean, for they have had their Enrons and
WorldComs, and the “true and fair view” was no help in those similar situations in
those countries. Just look at HIH Insurance in Australia for a recent surprise
corporate collapse accompanied by an unqualified audit report. Some have
suggested that the words should be interpreted by reference to Judge Friendly’s
decision in Continental Vending in the 1960s, which said that auditors could not
find a defense in reliance on generally accepted accounting principles. But that
decision is more than thirty years old, and subsequent court cases and administrative
decisions have not built on it and given it prominence, Suffice it to say, then, that

ACCOUNTING STANDARD SETTING AND REGULATION 313

there is no warp and woof to which we can refer for the meaning of “present fairly,”
and the legislative history of Sarbanes-Oxley offers no clues or help.

My bottom line about Sarbanes-Oxley is that it is of no help. Congress drilled a
dry hole in Sarbanes-Oxley. In fact, I think the investing public was and is being
misled about the efficacy of Sarbanes-Oxley. The mother of all securities legislation
since the 1930s, and it does not touch the real issues, which are accounting issues. It
will not stop future Enrons and WorldComs. Sure, maybe more miscreants in the
future will go to jail because of Sarbanes-Oxley, but that will be after disclosure of
irregularities, which will be of no help to investors who have lost money and to
employees who have lost their jobs and related benefits as in Enron. Nor will
Sarbanes-Oxley stop earnings management. Pre-Sarbanes-Oxley, earnings
management was like dirt; it was everywhere. Earnings management will continue
under Sarbanes-Oxley. Why is that? Well, it is because management of the reporting
enterprise, under generally accepted accounting principles, which principles remain
unchanged under Sarbanes-Oxley, has control of the accounting numbers.
Management determines whether and when and in what amount receivables are
booked, especially in service industries, and what the amount of allowance for
uncollectible receivables is. Inventory amounts and obsolescence of inventory are
determined by management. Cost of property, plant, and equipment is subject to
considerable management discretion as well in that many items are not always
capitalized, and the amount of construction interest capitalized is highly
discretionary As well, estimated useful lives, salvage values, and depreciation
methods with respect to fixed assets are highly discretionary. As mentioned earlier,
determining whether the carrying amount of fixed assets is recoverable is highly
discretionary. Whether tax benefits from operating loss carryforwards will be
realized is also up to management to decide, based on its gaze into the future. Take
a look at the accounting for motion pictures if you would like to see management
discretion in action. And if that is not enough for you, take a look at how banks
determine their bad debt allowances and casualty insurance companies determine
their claim liabilities, especially for their long-tailed lines —that is certainly
management discretion in spades. Finally, take a look at how impairment of
goodwill is determined; it is like watching a game of three-card monte on Times
Square.

Determining liability amounts for other than accounts payable, salaries payable,
and notes payable is also highly discretionary. Warranty allowances. Payables to
vendors when volume allowances are in play. (And as we have seen just last week in
the case of the Dutch grocer Royal Ahold, receivables from suppliers for volume
purchases are also subject to great discretion.) Income taxes payable. All of these
liability amounts are highly discretionary

So, what to do? Well, the FASB, more or less at the insistence of the SEC and
with prodding from Congress in Sarbanes-Oxley, is going to start writing principle-
based standards. The thought is that the current set of FASB standards is too, too rule-
driven, and that rules can be evaded by issuers of financial statements through
financial engineering. That, for example, Enron would not have happened had the

314 MARK TO MARKET ACCOUNTING

rule-driven model not been in play but instead a principle-based model had been in
play.

Let’s take a look at that proposal. I think that the current set of FASB standards is
no good, and that is an understatement. I have so contended, in writing, for many
years, but the FASB has not agreed with me. We have some 100+s FASB standards,
plus forty-six interpretations of standards, plus FASB staff documents that expand
on the FASB standards, plus I don’t know how many Emerging Issues Task Force
consensuses, plus a couple of dozen AICPA audit and accounting guides and
statements of position, plus a number of SEC staff accounting bulletins—all making
up the body of generally accepted accounting principles. It is more than most
accountants can comprehend. The FASB’s comprehensive publication on
accounting for financial instruments, for example, runs to more than 800 pages.
Reading that document, and financial statements that are produced by applying
that document, is like reading the Old Testament written in Aramaic—not
comprehensible to other than a very few scholars. And they often disagree on the
meaning of the words. For example, according to the Wall Street Journal of 28
January 2003, page A2, Freddie Mac, one of the largest users of derivative financial
instruments in the USA, will have to restate its 2002, 2001, and possibly 2000
financial statements because its new auditor disagreed with how Freddie Mac
accounted for some hedging transactions in prior years. So the high priests at
PricewaterhouseCoopers, the new auditor, disagreed with the high priests at Arthur
Andersen, Freddie Mac’s prior auditor. The Wall Street Journal says that “Many
investors have expressed concern that Freddie Mac’s financial statements are too
complex, in part because the accounting rules it must follow are so complicated.”
Indeed, rules written in Aramaic interpreted by accountants wearing skull caps. It is
little wonder that today’s financial reports are not understood.

So now we will get broad-based, principle-based standards. Let’s look at a current
broad-based, principle-based standard. Take a look at FASB Statement 5,
Accounting for Contingencies, issued in 1975 when I was a member of the FASB.
That standard started out to stop casualty insurance companies establishing so-called
catastrophe reserves in advance of the happening of the catastrophe, but it morphed
into the broadest, most all-encompassing standard ever issued by the FASB.
Statement 5 says that “An estimated loss…shall be accrued by a charge to income if
both the following conditions are met: (a) Information prior to the issuance of the
financial statements indicates that it is probable that an asset has been impaired or a
liability has been incurred at the date of the financial statements…and (b) The
amount of the loss can be reasonably estimated.” Those are high-sounding words.
When I signed FASB Statement 5 in 1975, I thought that those words, which I just
read, would work in the everyday world of accounting. Would work in determining
when, for example, to recognize and measure bad debts. Would work, for example,
in determining when to recognize and measure losses arising from injuries to
employees and customers and the public at large. Would work, for example, in
determining when to recognize and measure tax liabilities. Would work, for
example, in determining when to recognize and measure volume discounts to

ACCOUNTING STANDARD SETTING AND REGULATION 315

customers. But I found that the twin standards of “probable” and “reasonably
estimable” are so judgmental that they amount to no standard at all. Finance
companies and banks determine the timing and amounts of their loan loss
allowances under FASB Statement 5 with great variability. Insurance companies are
all over the lot in determining claim liabilities, both in timing and amount.
Liabilities for year-end bonuses and vacation pay vary from company to company.
Income tax liabilities are “ouija board” determinations, as are tax benefits from
operating loss carryforwards. FASB Statement 5 is a simple, broad-based, principle-
based standard that does not work in practice. Widespread adoption of that
approach will result in great variability in financial reports company by company.
Investors will not benefit from that approach. That approach will, in my opinion,
reduce security prices in general, without regard to company-specific risk, because
investors will be forced to take account of the variability in financial reports through
downward pricing of securities.

In addition, the FASB has been urged by many commentators to write standards
that require preparers of financial statements to look to the substance instead of the
form of transactions, and then account for the substance accordingly. The chairman
of the International Accounting Standards Board, in a memorandum submitted to
the British parliamentary Treasury Select Committee on 5 April 2002, when
speaking about accounting for specialpurpose entities, said, with obvious approval,
that the IASB’s Standing Interpretations Committee had identified four situations
where, in substance, the situation indicated that the financial statements of the SPE
should be consolidated. I think that the IASB will be disposed to similar utterances
in the future. The AICPA’s Quality Control Inquiry Committee, in an October
2002 memorandum entitled “Recommendations for the profession based on lessons
learned from litigation,” recommended to the FASB that in its revenue recognition
project and special-purpose entities project, the FASB place an emphasis of the
substance of transactions rather than their form. Various commentators on
accounting by lessees for leases have said that the substance of lease agreements is
that the lessee has a property right that should be recognized as an asset, with, of
course, a corresponding liability. The cry to account for the substance of transactions
can be heard in many districts.

The approach of principle-based standards and standards that refer to the substance
of transactions absolutely will not work. If the substance of transac tions, economic
conditions, and economic events is so clear that the substance can be discerned by
any reasonable person, then there is no need for a standard-setting body. Think
about it. If one can see, see clearly, the substance of transactions, there is no need
for an FASB or an IASB. Much the same problem is inherent in principle-based
standards. We have 15,000–17,000 public companies here in the USA. The ten
largest accounting firms serving those public companies have perhaps 4,000 to 6,
000 partners serving as engagement partners for those companies. In Great Britain
and continental Europe, there are about 5,000 public companies and probably 1,
000 audit partners serving as engagement partners for those companies. I don’t
know how many public companies there are in Canada, Mexico, Brazil, Japan,

316 MARK TO MARKET ACCOUNTING

India, Australia, New Zealand, Indonesia, South Africa, Israel, China, Hong Kong,
Russia, and the rest of the world where there are public companies. So, then, we
have the case where there are, let’s say, 25,000–30,000 individual CEOs and a like
number of CFOs all preparing their individual financial statements using their
individual, idiosyncratic judgments—all based on principles and substance without
reference to any descriptive, prescriptive accounting standards. On top of that, we
then have, let’s say, 6,000 individual audit engagement partners applying their
individual, idiosyncratic judgments to the financial statements that their 25,000–30,
000 clients have laid before them. Even if we assume that every one of those 50,000–
60,000 individuals is honest and well intentioned, we will have anarchy in financial
reporting.

So, then, what to do? Well, as I said at the beginning, I know how to fix this
problem.

First, we need simple, explicit, understandable definitions of assets and liabilities
instead of the FASB’s “probable future economic benefits” for assets and “probable
future economic sacrifices” for liabilities, which lets anything and everything be an
asset or a liability. Which definitions are understood only by FASB accountants, but
not by most other accountants and certainly not by ordinary folk. We need a simple,
descriptive, and prescriptive approach that will be understood by accountants, men
and women in Congress, and lay people, and which can be implemented from
Boston to Miami to Minneapolis to Los Angeles to Honolulu and indeed around
the globe. I would define an asset as cash, claims to cash, and things that can be sold
for cash. I would define a liability as cash outflows required by negotiable instruments,
contracts, law or regulation, and court-ordered judgments or decrees, and
agreements with claimants. Notice the orientation to cash. Cash is understood by
everyone. My sister understands cash.

Then we need to take control of the numbers out of the hands of management of
the reporting enterprise by requiring that the numbers for assets and liabilities come
from the marketplace. For non-cash assets, the amount of cash that the assets would
fetch in an immediate sale. For liabilities, the amount of cash that the obligee would
accept in immediate liquidation of his/her/its claim. You may ask where these prices
will come from. They will come from persons outside the reporting enterprise—
competent valuation experts having no familial or economic ties to the reporting
enterprise. And the names of those persons will go into forms 10-Q and 10-K so
that investors will know where the prices came from.

Will that approach cost more money than we are spending today for financial
reports. Most assuredly yes. But let’s look at the issue. How much does an Enron or
WorldCom cost? By some estimates, Enron alone cost $60–70 billion in lost market
value for investors. And that does not count lost 401(k) assets of employees, lost
benefits, and lost jobs. If we add up Enron, WorldCom, Waste Management,
Sunbeam, Cendant, Livent, MicroStrategy, Adelphia, Royal Ahold, and all the rest
of just the last five years, the amounts are huge. Maybe more than $100 billion. And
that does not count the immeasurable cost of lost investor confidence and the
consequent effect on security prices and the conse-quent effect on our economy here

ACCOUNTING STANDARD SETTING AND REGULATION 317

in the USA and economies around the world. If, by way of further example, we look
at the cost of the federal government S&L bail-out in the late 1980s and early
1990s, which bail-out was due, in significant part, to bad accounting, the cost to the
US taxpayer was several hundred billion dollars. Bad accounting can cost, and has
cost, mega bucks.

By my estimation, annual external audit fees in the USA for our public
companies are of the order of $8–10 billion. That amount does not include fees for
the audits of 7,000 mutual funds and 7,000 broker/dealers, which already mark to
market every day at the close of business. If we assume that the $10 billion were to
be doubled or even tripled if issuers had to go to outside experts to determine the
cash market prices of their assets and liabilities, we would be looking at fees of $20–
30 billion. If we prevented just one Enron per year by requiring mark-to-market
accounting, we would easily pay for that additional cost. And when considered in
relation to the total market capitalization of just the US corporate stock and bond
markets of $15 trillion or so, the additional cost of $10–20 billion would be small
indeed.

Will my proposal solve all of the problems in financial reporting? No. But, at
least we would be working toward getting relevant numbers. Numbers that are real
and have their foundation in the marketplace.

Let me list just a few of the benefits:

1 Financial reports would be understandable to retail and institutional investors,
Congress, and the public at large.

2 Financial reports would have increased usefulness in making investment,
lending, corporate governance, and public policy decisions.

3 We would do away with today’s mountain of accounting rules that nobody
understands.

4 We could do away with the FASB and the IASB.
5 We could do away with the 150-hour education requirement for CPAs—no

mountain of rules to memorize.
6 And, finally, continuing professional education requirements for CPAs could

be scrapped.

Thanks for your attention.

Notes

1 I am indebted to Professor Peter W.Wolnizer, University of Sydney, for
“serviceability” and “fit for intended use.” See Wolnizer, Auditing as Independent
Authentication, Sydney University Press, 1987.

2 The US General Accounting Office, in GAO-03–138 dated 4 October 2002, found
919 retrospective restatements of financial statements for irregularities by 845 public
companies between January 1997 and June 2002. Similarly, in a report dated January

318 MARK TO MARKET ACCOUNTING

2003, Huron Consulting Group found 1,207 retrospective restatements in the five
years ended 31 December 2002. See huronconsultinggroup.com.

ACCOUNTING STANDARD SETTING AND REGULATION 319

47
IASC due process

Sir Bryan Carsberg
International Accounting Standards Committee

167 Fleet Street
London EC4A 2ES

England
12 August 1997

Dear Sir Bryan,
This letter concerns the IASC’s due process.
Last week, I inquired of Ms Rivat of your staff as to why IASC standards do not

include dissents of member delegations who disagree with the standard. Ms Rivat
told me that the IASC’s constitution prohibits publication of dissents in exposure
drafts and final standards. It is unbecoming and inappropriate for a body such as the
IASC to preclude publication of dissent. Transparency is the hallmark of good
financial reporting. Transparency should be the first principle of the IASC’s
operations. I urge you to do what is necessary to remove that prohibition from the
constitution.

The IASC’s final standards are issued bare of explanation. Standards do not
include the reasons for the need for the standard. Because of the constitutional
prohibition, standards do not include identification of dissenting delegations along
with the reasons for their dissent. Also not included in final standards is a “basis for
conclusions” wherein the assenters to the standards set out the reasons for
concluding the way they did and why the assenters believe that the reasons put forth
by the dissenters are insufficient or incorrect. I recommend that future exposure
drafts of standards and final standards include (1) the reason for issuing the
standard, (2) a basis for conclusions setting forth why the proposed standard or final
standard requires what it does and why any dissenters’ reasons are insufficient or
incorrect, (3) identification of the dissenters and the reasons for their dissent, (4) a

brief explanation of other plausible approaches that could have been taken in the
proposed standard or final standard even if none of those approaches is supported
by a dissenter and why the IASC board believes such approaches would be
insufficient or incorrect, and (5) the reasons for changes in the final standard from
the exposure draft.

The importance of the IASC as a successful standard-setting body is
acknowledged. The IASC needs to help to guarantee its own success by issuing
standards that, first, produce relevant and reliable information for use by investors
and, second, stand on their own feet by reason of persuasion by the IASC board in
the published basis for conclusions. As you know, standard setting is not easy. What
would be the correct or best accounting treatment for a particular issue is generally
not obvious or intuitive. Even among investors and financial analysts what would be
the correct or best accounting treatment in a particular circumstance is generally
contentious. That contention is vastly increased when investors, financial analysts,
preparers of financial statements, preparers’ outside auditors, and regulators are all
involved in the standard-setting process, either by participating directly at the
standard-setting table or indirectly by making their own proposals for consideration
by the IASC, by commenting on discussion documents or exposure drafts issued by
the IASC, by participating in field tests or at conferences where accounting issues
are discussed, or by accepting, for regulatory purposes, the results of preparers of
financial statements applying the final standard in the preparation of their financial
statements with opinions thereon by their outside auditors. That contention
generally will not go away just because the IASC issues a standard, but acceptance of
and compliance with the standard will be enhanced if the IASC carefully and
persuasively explains, in both the exposure draft and final standard, why the
standard is necessary and why the IASC concluded the way it did and why the IASC
did not find other approaches or proposals persuasive or appropriate.

People within the IASC’s inner circle—IASC board members, steering committee
members, IASC staff, and official observers of IASC board meetings —know why a
particular standard was necessary, why the IASC board reached the conclusion it
did, why other approaches were rejected by the IASC board, and why changes were
made between the exposure draft and final standard. However, that inner circle of
people is a very small number when considered in relation to all the people who are
affected by IASC standards. Many people outside the IASC’s inner circle are or will
be vitally interested in the IASC’s standards. Stock exchanges, federal and state
securities regulators, and federal and state accountancy boards that license
accounting practitioners and mandate continuing accounting education by licensed
accounting practitioners obviously have a great interest in what the IASC board
does and how it reaches its decisions; those bodies, who mostly are outside the IASC’s
inner circle, may be hesitant to embrace IASC standards as being in the best
interests of investors if those standards are not fully completed with careful and
persuasive reasoning. Likewise, most preparers of financial statements and their
outside auditors are outside the IASC’s inner circle; those people need to be

MARK TO MARKET ACCOUNTING 321

informed as to why the standard was necessary and the IASC board’s reason for the
approach taken. Most investors and financial analysts are also outside the IASC’s
inner circle and similarly need to be informed. Lastly, and perhaps most
importantly, teachers of accounting and their students need to be informed by the
IASC as to why a standard was issued and the reason for the conclusion reached and
why other approaches were rejected; if they are not so informed, then all they can do
is memorize the standard and apply it in a robot-like fashion. Understanding of
IASC standards by students, who will be tomorrow’s accountants, depends on
students being fully informed by the IASC through careful and persuasive reasoning
and not by issuing standards bare of explanation.

I wrote to you earlier this year (May 27) about the IASC’s due process. You
responded by saying that you were referring the matter to the Strategy Working
Party. I hope you will refer this letter as well and make such changes as you can on
your own in advance of recommendations by the Strategy Working Party.

Yours truly,
Walter P.Schuetze

cc: Mr Arthur Levitt and Mr Michael Sutton, SEC
Ms Jane Adams, AICPA
Mr Anthony Cope, FASB

International Accounting Standards Committee
167 Fleet Street

London EC4A 2ES
United Kingdom

Email: iase@iase.org.uk
20 August 1997

Mr Walter P.Schuetze
8940 Fair Oaks Parkway

Boeme
TX 78015, USA

Dear Walter,
Many thanks for your letter of 12 August about IASC’s due process. I share your

view that there is room for improvement in our due process and that improvement
is particularly important in the context of IASC’s current objectives. I want to bring
about the situation where IASC’s procedures are regarded as being as good as we can
make them, within unavoidable resource constraints, for the purposes of establishing
internationally harmonized standards.

You focus particularly on the desirability of having a basis for conclusions and
explanations of alternative approaches with arguments for and against the different
approaches. As I have said before, and as you acknowledged in your letter, I have
always intended that our Strategy Working Party should undertake a thorough
review of all due process issues. I believe it is almost certain that the working party will

322 ACCOUNTING STANDARD SETTING AND REGULATION

agree that a basis for conclusions is desirable. On the basis of early discussions in the
working party, it also seems likely that the working party will recommend that
board meetings should be open to the public for attendance in person or by
telephone. If that is the case, identifying dissenters is a very small step. We might
prefer to adopt a slightly different approach towards explaining dissents from that
adopted at the FASB simply because of the force of numbers. (Although this will
have to be worked out in the context of the details of any changes in structure that
are proposed.) We might agree that the views of dissenters would be explained by the
staff as part of the basis for conclusions or in a separate section of the standard in
consultation with the people who are the dissenters. In any case, something along
these lines seems to be needed.

I will make sure that these issues are considered by the Strategy Working Party. I
suspect that our board may wish to await the recommendations of the working
party before making any changes in existing procedures, although we shall be
keeping in mind the possibility of making some recommendations early and
implementing them right away. Whatever the outcome, I am most grateful to you
for taking the trouble to write about these matters.

Sir Bryan Carsberg
Secretary-General

cc: Mr Arthur Levitt
Mr Michael Sutton, SEC
Ms Jane Adams, AICPA
Mr Anthony Cope, FASB
255

MARK TO MARKET ACCOUNTING 323

Index

Accounting Horizons 3
Accounting Principles Board (APB) 22–3,

270
Accounting Standards: Building

International Opportunities for Australian
Business’ (CLERP 1) 12

ADC (acquisition, development
andconstruction) projects:

S&L debacle 4–0, 94–7, 181;
thrift loans on 25–6, 195–6

Adsteam xv
advertising, cost of as asset 72, 73
airlines:

auditor independence 211;
historical cost misleading since
September 11th 293, 305, 312–10;
valuing aircraft 80

Ameen, Philip 299
American Accounting Association:

Schuetze’s address to (1992) 89–9;
Schuetze’s address to (1994) 109–15;
Schuetze’s address to Southwest
Regional Meeting (2003) 309–15

American Institute of Certified Public
Accountants (AICPA) 22, 23, 25, 60,
100, 269, 270;

Committee on Accounting Procedures
250–50;
Public Oversight Board, Schuetze’s
comments on special report by 217–22;

Schuetze’s address to National
Conference (1992) 84;
Schuetze’s address to National
Conference on Banking (1993) 259–63;
Schuetze’s address to National
Conference on Banking (1994) 273–5;
Schuetze’s address to National
Conference (1998) 278–80

Anderson, George 282
Ansett xv
Arthur Andersen 303
Arthur Young 210
assets:

accounting for assets and liabilities 33;
acquired identifiable intangible assets
159–9;
cost of purchased goodwill 111–15;
disposal of 42;
as economic benefit 167–6;
elements that constitute 64–9;
estimating selling price 5;
FASB fails to follow their own definition
of 159;
FASB’s definition 7, 34–7, 49–2, 53–8,
70–5, 146–8, 149–50, 293–1, 304–3;
goodwill 156–8, 160–2, 166;
impairment of 136–8;
leased and owned 177;
and liabilities 58;
long-lived assets 153–5;
non-real assets 304–3;

324

as probable future economic benefit 73;
recognized as cost 54–8, 57, 71–4;
reporting of and Enron collapse 304;
representing contractual claims to cash
64–7;
Schuetze’s proposed definition 7, 56, 73–
7, 169, 298, 317;
swaps of assets 304;
to be held and used 153–5

Associated Securities Ltd xv
Association for Investment Management and

Research (AIMR) 282
auditing:

and accounting 187;
audit fees 317;
auditability 180;
auditor liability 181, 200;
implications of accounting practices for
179–86;
internal audit outsourcing 277–5;
internal controls, reporting by
independent auditors on 201–6;
Schuetze on auditors’ responsibilities 79

Auditing as Independent Authentication
(Wolnizer) 79

auditor independence 4, 183–3, 187, 208–
15, 227–6, 243–2;

enforcement cases 285–3;
Kirk Panel 184, 282–80;
KPMG Peat Marwick case 285–3

Australia:
‘Accounting Standards: Building
International Opportunities
for Australian Business’ (CLERP 1) 12;
Corporate Law Economic Reform
Program (CLERP) 12;
mark-to-market accounting 12;
meaning of ‘true and fair’ 313;
opposition to market value principles 14;
recommended addition to Corporations
Act 16
autobiography (Schuetze) 19

banking:
Schuetze’s address to AICPA National
Conference on Banking (1993) 259–63;

Schuetze’s address to AICPA National
Conference on Banking (1994) 273–5

Banking Housing and Urban Affairs (US
Senate Committee) Schuetze’s testimony
5, 14, 15;

Schuetze’s testimony on Enron collapse
302–6

Bayless, Robert 102
BCCI xv
Beresford, Denny 259, 273
Berkshire Hathaway 116
Bond Corporation xv
bonds 262;

bond holdings 25–7, 82;
bond liabilities, reporting of 29–1;
convertible bonds 48;
historical cost accounting 91–4;
marked to market 292–90

Bradley, William 255
Breeden, Richard 12, 25, 37, 89;

mark-to-market accounting 87, 292
bridges, Schuetze’s analogy 5, 14, 306, 307
‘bright lines’ 87
Briloff, Abraham 163
broker/dealers 15, 16
Buffet, Warren 7, 116
Bullen, Halsey 42, 119
business combinations:

intangible assets 146–52, 156–9;
negative goodwill 144–6

California Public Employees Retirement
System 271

Cambridge Credit xv
Canada, deferral of transaction gains and

losses 271
capital adequacy 93
capital markets:

capital markets approach 12, 270–9;
role of financial accounting and
reporting 38, 241–40, 250–53,
see also investors

Carey, John L. 208, 210, 216
carrying amount of an asset 42
Carsberg, Sir Bryan 30, 44, 134, 245–4
cash:

assets as 34, 162;

INDEX 325

cash selling prices 13;
estimating cash selling prices 8, 82;
securities, contractual claims to cash 64–
7

cash flow:
cash flow statements 281;
standardized measure of 180

Cendant 4, 14, 303
Certified Public Accountants (CPAs) 100
Chambers, Raymond J. 6, 290;

market selling price accounting 10;
market selling prices 14;
R.J.Chambers Research Lecture,
Schuetze’s address on mark-to-market
accounting in USA (2001) 11, 15, 290–
99;
‘true and correct/fair’ 10

Checkosky and Aldrich case 288–6
Cheney, Dick 312
Ciesielski, Jack 117
commercial perspective, definition 12
Committee on Accounting Procedure 269–8
common stock equivalent 47
Communism, fall of as opportunity 101–3
compensation committee report 221
compound instrument 166
Computer Associates International Inc. 28
Congrès Fédération des Experts Comptables,

Schuetze’s address to Congress of (1993)
250–53

constructive obligation 140
contingencies: accounting for 315–13;

contingent liabilities/assets 138–41
Continuously Contemporary Accounting

(CoCoA) 6
control, FASB on 148
convertible bonds 48
Coopers and Lybrand 288
Corporate Law Economic Reform Program

(CLERP) (Australia) 12
Corporation Finance Division, Securities

and Exchange Commission 267
Corporations Act (Australia), recommended

addition to 16
costs:

cost of implementation (mark-to-market
accounting) 14, 317;
cost-based accounting 179;

definition 49;
not assets 41;
recognized as assets by FASB 54–8, 57,
71–4;
as resource 249

credit losses 86, 91–4
credit risk 126
creditors, requirement for transparent

accounts 3
Cummings, Joseph P. 22, 23, 84

Daimler Benz 255, 272
debt securities 89;

managed income 91
decommissioning (nuclear industry), cash

outflows 131–4
deferred tax accounting 48–1, 70
deferred tax assets 96, 200
depreciation 68, 80
derivatives 242, 262;

accounting for 276–4, 281–9;
derivative contracts 70;
disclosures about 273–3

Diacont, George 89
discount rates:

credit standing of borrower 44;
environmental remediation 131–4;
pension liabilities 134–6

double counting, stock options issued to
employees 172–70

earnings management 9, 81, 295–7, 305;
reserves used to manipulate earnings 40;
Sarbanes-Oxley Act 314,
see also enforcement

Eaton & Huddle, Schuetze works for 21, 28,
290

Eaton, Marquis 21
economic benefit, assets as 167–6
economy 98–1
Elliott, Robert 299
Emerging Issues Task Force 47
enforcement 109–15, 225–30, 243;

auditor independence 285–3;
Checkosky and Aldrich case 288–6;
fraternization, auditors and clients 227,
289–7;

326 INDEX

non-audits 287;
reluctance to bring fraud cases 61;
statistics 225–4, 283–2,
see also auditor independence;
earnings management;
fraud;
premature revenue recognition;
‘reserves’

Enforcement Division, Securities and
Exchange Commission 268
Enron Corp. xv, 311, 314;

cost of failure 14, 317;
Schuetze’s testimony 302–6;
and SPEs 174

Enronitis xv, 16
environmental remediation, cash outflows

131–4
Epstein, M.J. 60, 64
equity, reporting falling values 94
Equity Funding xv
Eshoo, Anna 255
Esperanto (international financial

accounting) 237, 249
ethics:

auditor independence 4;
ethical standards 101

exit plan, accounting for restructuring 105–8
exit prices 13;

exit price accounting 6,
see also cash

expense, definition 171
external auditing:

cost of 307–6;
and internal audit outsourcing 277–5

failure (corporate failure):
and accounting 4;
cost of 14;
timing of recognition of liabilities 42,
see also Enron Corp.
fair value 68, 88;
business combination accounted for as a
purchase 150;
environmental remediation liabilities
131–3;
FASB definition 78;
and historical cost accounting 151;

impairment of assets 136–8;
long-lived non-monetary assets 188–93;
non-monetary assets 180;
pension liability 136;
Schuetze’s proposed definition 78–2;
and SPEs 176;
transfers of receivables 129–30;
verifiability 180

‘feel-good’ accounting 69–2
Financial Accounting Standards Board

(FASB) 5, 270;
accomplishments since inception 278–
80;
accounting for restructurings 39;
bond holdings, need to mark to market
27;
carrying amount of an asset 42;
control 148;
costs recognized as assets 54–8, 57, 71–
4;
definition of assets 7, 34–7, 49–2, 53–8,
70–5, 146–8, 149–50, 293–1, 304–3;
definition of fair value 78;
definition of liabilities 7, 36, 43–6, 74–8,
106–9, 294–2;
financial instruments project 261–60;
financial statements based on concepts 6;
footnotes 60–3;
goodwill 41, 160–2;
monitored by SEC 27;
reluctance to accept mark-to-market
accounting 12;
role of 257;
Schuetze’s criticism of complexity of
statements 45;
Schuetze’s work with 23–4, 25, 29

Financial Executives Institute (FEI) 191;
Schuetze’s address to 102–10;
value at risk 275

financial institutions, auditing of 22
financial instruments 119–3, 281;

accounting for 164–4;
management intent 250

financial instruments project 240–9;
FASB 261–60

Financial Reporting Institute Conference,
Schuetze’s address to (1993) 217–22

financial statement restatements 17n

INDEX 327

fixed assets 70
footnotes (FASB’s) 60–3
Ford, Dean Dennis 98

foreign currency:
foreign currency translation 24, 280;
transaction gains 259

Franklin Savings 48
fraternization, auditors and clients 227, 289–

7
fraud:

how to eradicate fraudulent financial
reporting 79;
prevention of, public reporting on
internal controls 204–3;
reluctance to bring fraud prosecutions
61,
see also enforcement

fraudulent financial reporting 182
Freddie Mac 315
futures contracts 47

General Electric (GE) 100, 271
General Motors 100, 271
Germany, true financial position masked

271
GI Bill of Rights (USA) 21
Gilliland, Frank 19
Global Crossing 4
goodwill 40, 41;

assets 156–8, 160–2, 166;
cost of goodwill as asset or not 156–8,
160–2;
negative goodwill 144–6;
purchased goodwill 71;
restructuring charges 113

governance, and financial reporting
problems 4

Great Depression 269
guarantee liabilities 44, 173, 176

H.G.Palmer xv
Haas School of Business, Schuetze’s address

to (1993) 255–7
Halliburton 312
harmonization see international standards

hedging instruments, accounting for 262
Herdman, Robert 300

HIH Insurance xv, 297, 313
historical cost accounting 13, 89–3;

credit losses 91–4;
historical cost used instead of fair value
68;
interest rate risk 91;
investment and lending decisions 89;
managed income 91;
savings and loans debacle 37

Holton, Tom 21, 25, 28, 290
Huddersfield Banking Company 11
Huff, Barry 84
Hunt, Issac 298
Huron Consulting Group 311;

Report 244

impairment:
assets to be tested for 153–5;
disclosure 180;
impaired loans 92–5, 181, 199, 206–5;
long-lived assets 188–93;
stocks 192

income statements 280
income tax accounting, complexity 47
independence, auditor independence 4, 183–

3, 187, 208–15
independent auditors, internal controls 201–

6
information:

control of 179;
cost of privacy 136, 253

insurance, auditor independence 213
intangible assets 141–5;

acquired identifiable intangible assets
159–9;
business combinations 146–52, 156–9

interest rate risk, historical cost accounting
91

interest rate swap 276
internal auditing, outsourcing 277–5
internal controls:

independent auditors 201–6;
internal control systems 185, 221–22

International Accounting Standards Board
(IASB) 13;

reporting of liabilities 29–1

328 INDEX

International Accounting Standards
Committee (IASC) 22, 27–9, 253;

contingent assets and liabilities 43;
Schuetze’s address to (1992) 246–8:
Schuetze’s letter to (1997) 319–19;
value in use 41–4

international standards:
mutual recognition approach 238, 250–
53;
standard setting 88–1, 235, 236–6, 246–
8

intuition, financial accounting should be
based on 61

Investment Company Act (1940) (USA) 89
Investment Management Division, Securities

and Exchange Commission 267–6
investment versus trading, long-term

portfolios 96
investors 98–1;

diminution of confidence 4;
financial statements following FASB’s
standards of limited use to 24;
goodwill as asset or not 162–2;
requirement for transparent accounts 3;
role of financial statements 250–51

ISF (Internal Service Fund) assets 263–2

Japan, taxable income 271
Jenkins, Ed 282
Joint Stock Companies Act (1844) (UK) 10

Kirk, Donald 183, 282
Kirk Panel 184, 282
KPMG:

KPMG LLP, Schuetze’s work with 21,
24;
thrift loans to ADC projects 25

KPMG Peat Marwick 228;
auditor independence case 285

Latec Investments xv
lease accounting 47, 48, 86;

auditor independence 212
leases 177
Lee, T.A. 6
Leisenring, Jim 280
letters (Schuetze’s) 40

Levin, Carl 51
Levitt, Arthur 273, 292, 295, 299
Levy, David 298
liabilities:

accounting for assets and liabilities 33,
58, 305;
accounting for financial instruments
164;
accounting for restructuring 39;
elements that constitute 67;
estimating 5;
FASB’s definition 7, 36, 43, 74, 106,
294;
liability crisis 180, 195, 217;
‘no realistic alternative’ and ‘constructive
obligation’ 138;
present obligation 156;
reporting of 29;
restructuring charges 106, 114;
restructurings, recognizing liability for
future expenditure 75;
Schuetze’s proposed definition 8, 36, 76,
317;
timing of recognition of 42

Lieberman, Joseph 255
liquidity risk 126
litigation 95;

auditor liability 181;
problems regarding definition of assets
71

Litke, Arthur 29
Livent 4, 14, 303
loans 64;

loan fees 281;
loan impairment 92, 181, 199, 206;
loan losses 81;
problem created by reporting historical
cost 305;
reverse mortgage loans 27,
see also savings and loans (S&L) debacle

loans receivable 70;
contractual claims to cash 64,
see also ADC;
savings and loans

London School of Business 61
long-lived non-monetary assets, fair value

188
loss contingencies, FASB 24

INDEX 329

MacDonald, Elizabeth 229
Mainline xv
managed income, historical cost accounting

91
management functions, and external audit

277
management intent 250
mark-to-market accounting:

benefits of 245;
Breeden on 87

market efficiency, mark-to-market and
historical cost accounting 93

market price data, naming source 4
Market Regulation Division, Securities and

Exchange Commission 267
market selling price accounting 10
market selling prices 14
market value principles 14
Maxwell Corporation xv
mergers 114
Merrill Lynch 25
MicroStrategy 4, 14, 303
Millstein, Ira 62, 295
Millstein—Whitehead Blue Ribbon
Committee 295
Minsec xv
multi-jurisdictional disclosure system 248
mutual funds 15, 16
mutual-recognition approach (international

standard setting) 238, 250

Needham, James 292
Newlove, George 21
non-audits 287
non-monetary assets, fair value for long-lived

non-monetary assets 180, 188
nuclear decommissioning, cash outflows

131

obligation, present obligation and liability
156

Office of Chief Accountant, Securities and
Exchange Commission 268

oil companies 199
oil crisis (1976) 25
O’Malley Panel 297
O’Malley, Shaun 295

One.Tel xv
open-ended mutual funds 100
operating companies:

purchased goodwill 158;
restructuring charges 112

Palepu, K.G. 60, 64
payment-in-kind (PIK) bonds 206
payroll costs, auditor independence 212
Peat, Marwick, Mitchell & Co. (Peat

Marwick) 21, 22, 290;
Department of Professional Practice
(DPP) 22, 24–5

peer reviews 185, 217–18, 224n, 307
Penn Central xv, 5, 304, 306
pension liabilities:

auditor independence 213–13;
discount rate for 134–6;
reporting of 29–1

pensions:
accounting for pension benefits 75, 261,
263;
market value 89;
pension accounting 45–9, 70;
pension funds 100, 240;
pension plan values 96;
standard setting 240

Peoples, John 22
Pergamon xv
Petersen, Melody 229
Pickett, Edwin 98
Pitt, Harvey 294, 299, 300, 306
pooling accounting 160, 163
pooling-of-interests accounting 86, 150–2
premature revenue recognition 114,

see also enforcement
price risk 126
principle-based standards 315–13
probability approach, long-lived assets 191
property taxes, real and personal property

taxes 69–2
prosecutions:

reluctance to bring fraud cases 61,
see also enforcement

provisions, liability recognition 138–41
purchase versus pooling 81
purchased goodwill 40, 41

330 INDEX

Qintex xv

R.J.Chambers Research Lecture, Schuetze’s
address on mark-to-market accounting in
USA (2001) 11, 15, 290–99

Ray Garrett Jr Corporate and Securities Law
Institute, Schuetze’s address to (1999)
114–20

realism, need for 95
receivables 64;

accounting for 42–5;
contractual claims to cash 64;
transfers of 47, 123–31

Reid Murray xv
related party disclosures 280–8
relevance, need for in financial accounting

36–9
research and development (R&D) (costs) 23–

4, 141;
as assets 72;
disclosure 280
‘reserves’ 187–6;
enforcement 111, 229–8;
manipulation of earnings 40;
restructurings 114–20

responsibilities, declaration of 220–19
restructurings:

accounting for 39–2, 102–10;
liabilities 106–9;
recognizing liability for future
expenditure 75;
reserves, accounting for 114–20;
troubled debt restructurings 95–8

revenue 195–5;
improper revenue recognition 79

reverse mortgage loans 27–8
Rivat, Rivat 319
Rothwells xv
Royal Ahold 311, 312, 314
Ruder, David 221
Russian, Schuetze’s knowledge of 19–1

salvage values 80
Sarbanes-Oxley Act (2002) (USA) 183, 244–

3, 311–11
Saul, Ralph 282
Savin Corporation 288

savings and loans (S&L) debacle 37, 80, 94–
7, 180–80, 195–6, 206, 290–9, 304, 305–
4

Schuetze, Walter P.:
autobiography 19;
biographical sketch 2

Schumer, Charles, Senator 42, 43
securities 64–7;

contractual claims to cash 64–7;
definition of outstanding security 47;
marked to market 292;
market prices of 29

Securities and Exchange Commission (SEC)
12;

assets 34–7;
current developments at (1998) 283–7;
Investment Management Division 267–
6;
mark-to-market accounting 292;
Market Regulation Division 267;
Office of Chief Accountant 268–7;
reverse mortgage loans 27–8;
role of chief accountant 27, 28;
Schuetze as reviewing partner for Peat
Marwick 23, 25;
Schuetze’s address to (1993) 217–22;
Schuetze’s address to SEC and Financial
Reporting Institute Conference (1998)
283–7;
Schuetze’s work with 25, 25, 27, 28;
SEC filings 96–9;
work of 265–7

Securities Law Institute, Schuetze’s address
to (1999) 114–20

securities laws 255–5
segment reporting 280
segments 48
Sensormatic Electronics Corporation 228–7
separability, asset recognition 143–5
‘serviceability’ 244, 309
Shanahan, John 259, 273
shares, as liability or not 164–4
Shepherd, George 22
simplicity (need for) 35–9, 45, 58
sister (Schuetze’s), use as guidepost 63
social interactions with clients, need to Iimit

4
special-purpose entities (SPEs) 44–7, 174–4

INDEX 331

speeches (Schuetze’s) 36
Sprouse, Robert 29
standard setting 235–44;

banking 259–63;
broad, general standards as impractical
86;
function in financial markets 269;
International Accounting Standards
Committee 319–18;
international standards 88–1, 235, 236–
5, 246–8;
mutual recognition approach,
international standards 250–53;
private-sector standard setting 255–7

Stanhill xv
Sterling, Robert R. 6;

cash selling prices 13;
market selling price accounting 10

stock options 81;
accounting for 167–70, 214–14;
auditor independence 212;
disclosure of 278;
issuance of not an expense 43

stocks, impairment 192
substance of transactions 316
Sunbeam 4, 14, 303
Swieringa, Bob 109

termination benefits, accounting for
restructurings 104

thrifts, loans of ADC projects 25
TIAA/CREF 271
time value of money 259–9
TransMontaigne Inc. 28
transparency 272;

IASC, publication of dissents 319, 322–
19;
as illusion 61

Treadway Commission 185, 204, 220–19,
223

‘true and correct/fair’, meaning of 10
Turner, Lynn 299
Tweedie, David, Sir 243, 278

UK:
Joint Stock Companies Act (1844) 10;
meaning of ‘true and fair’ 313;

writing up of fixed assets 271
unit of measurement (US dollar) 67
University of California, Schuetze’s address

to Haas School of Business (1993) 255–7
University of Southern California,

Schuetze’s address to SEC and Financial
Reporting Institute: (1993) 217–22;

(1998) 283–7
University of Sydney, R.J.Chambers

Research Lecture, Schuetze’s address on
mark-to-market accounting in USA
(2001) 11, 15, 290–99

University of Texas:
School of Business 28;
Schuetze’s address in Distinguished
Lecture Series (1993) 265–70;
Schuetze’s address to Austin Theta
Chapter (1993) 98–3
USA, accountancy rules compared with
other countries 271–70

‘value at risk’ 242, 275–3
value in use 41–4
verifiability 107, 180
VF Corporation 117
Volcker, Paul 299

Walgreen 117
Wallis, Grace 19
Waste Management 4, 14, 303
Welch, Sandy 309
Welsch, Glenn 21
Westmex xv
White, John 21
Whitehead, John 62, 295
Wilson, Logan 98
Wolnizer, Peter W. 6, 7, 28, 79;

‘true and correct/fair’ 10
World Congress of Accountants 34
WorldCom xv, 311, 317
Wyatt, Arthur 246

332 INDEX

Book Cover

Half-Title

Title

Dedication

Contents

Notes on author and editor

Foreword

Letter from Fred Talton

Acknowledgments

1 Walter P.Schuetze

A call for accounting and auditing reform

“True north” in financial accounting and reporting

Mark-to-market accounting: historical and contemporary perspectives

The cost of implementing mark-to-market accounting

Who should mandate mark-to-market accounting?

A concluding comment

Notes

Bibliography

2 Autobiography

Addendum

Part I Accounting for assets and liabilities

3 Schuetze on accounting for assets and liabilities

The articles

The speeches and addresses

The letters

4 Keep it simple

Notes

5 What is an asset?

6 What are assets and liabilities?

References

7 New chief accountant’s wish list

8 Relevance and credibility in financial accounting and reporting

9 Why are we all here anyway?

10 Accounting for restructurings

11 Enforcement issues, and is the cost of purchased goodwill an asset?

12 Cookie jar reserves

13 Financial instruments

Appendix A

Financial instruments

14 Accounting for transfers of receivables (by Tom, Dick, and Harry)

Notes

15 Discount rate re cash outflows for nuclear decommissioning and environmental remediation

16 Discount rate for pension liabilities

17 Exposure Draft E55: Impairment of Assets

18 Exposure Draft E59: Provisions, Contingent Liabilities, and Contingent Assets

19 Exposure Drafts E60: Intangible Assets, and E61: Business Combinations

20 Business combinations and intangible assets

21 Accounting for the impairment or disposal of long-lived assets and for obligations associated with disposal activities

22 Business combinations and intangible assets

23 The FASB and accounting for goodwill

24 Accounting for financial instruments with characteristics of liabilities, equity, or both

25 Accounting for stock options issued to employees

26 Proposed interpretation: guarantor’s accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others …

27 Your proposed interpretation

Part II The implications of accounting practices for auditing

28 Schuetze on the implications of accounting practices for auditing

The articles

The speeches and addresses

29 Disclosure and the impairment question

Impairment and the winds of change

Little clarity in the literature

Inconsistencies in practice

Proposals and projects

Roadblocks to recognition and measurement criteria

An interim solution

A practical alternative

A field test for disclosure

30 The liability crisis in the USA and its impact on accounting

31 Reporting by independent auditors on internal controls

Who wants it?

Is there a cost benefit?

Will it prevent fraud?

The problem of ambiguous accounting principles

The potential for over-reliance

Not a solution

32 A mountain or a molehill?

33 Comments on certain aspects of the special report by the AICPA’s Public Oversight Board of 5 March 1993

Notes

34 Enforcement issues

Postscript

Part III Accounting standard setting and regulation

35 Schuetze on accounting standard setting and regulation

The speeches and addresses

The letter

36 The setting of international accounting standards

37 What is the future of mutual recognition of financial statements, and is comparability really ncessary?

38 A note about private-sector standard setting

39 Take me out to the ball game

40 Financial accounting and reporting in our worldwide economy

41 SEC accounting update

Introduction

Disclosures about derivatives

Accounting for derivatives

Internal audit outsourcing

42 A review of the FASB’s accomplishments since its inception in 1973

43 Current developments at the SEC

Postscript

44 A memo to national and international accounting and auditing standard setters and securities regulators (a Christmas pony) …

Postscript: 9 December 2001

Notes

45 Hearing

46 Watching a game of three-card monte on Times Square

Notes

47 IASC due process

Index

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