The Crisis in Financial Reporting
Rick Antle
Senior Associate Dean and Professor of Accounting
Yale School of Management
October 17, 2002 3
Criticized Parties
• Government regulators
• Standards’ setters (FASB & EITF)
• Management
• Boards of directors
• Accounting profession
October 17, 2002 4
Debacle
• A sudden, disastrous collapse, or defeat; a rout
October 17, 2002 5
Fiasco
• A complete failure
October 17, 2002 6
Failure
• Cessation of proper functioning or performance
October 17, 2002 7
“I am not an accountant.”
October 17, 2002 8
Basis of Financial Reporting
• Economic concepts
• Accounting conventions
• Institutional context
October 17, 2002 9
Accounting Identity
Assets = Liabilities + Equity
Assets – Liabilities = Equity
October 17, 2002 10
How it Works
• 0 – 0 = 0?
• 5 – 3 = 2?
• RECOGNITION CRITERIA!!
October 17, 2002 11
Building Example
• Original cost: $6 million
• Accumulated depreciation: $4 million
• Sales price: $3 million
• Does selling the building add to shareholders’ wealth?
October 17, 2002 12
I Am Not An Accountant
• Professes confusion of the aspirations of accounting with the practical results of applying its conventions and techniques.
October 17, 2002 13
Standards’ Setters
• FASB’s elaborate due process means:
Details and loopholes are there because someone wants them there.
• Just look at the treatment of executive stock options.
October 17, 2002 14
Special Purpose Entity - Problem
RiskyCorp
Wants to borrow $100 to build an office building, which it will occupy
OfficeCorp
A special purpose entity. Will issue debt, construct the office building, and lease it to Risky Corp
Big Bank
Loan
Payments(Interest rate?)
October 17, 2002 15
Special Purpose Entity - Consolidated
RiskyCorp
OfficeCorp
Big Bank
LoanPayments
Lease Payments
Use of office building
Risky Corp & Subsidiary
October 17, 2002 16
Special Purpose Entity - Off Balance Sheet
RiskyCorp
OfficeCorp
Big Bank
LoanPayments
Lease Payments
Use of office building
Outside investors
EquityDividends
Loan guarantee
October 17, 2002 17
Dialog One
• How about $0.1 of equity for Office Corp?
• Not enough? How about $0.02?
• Still not enough? Ok, you tell me, how much equity is enough?
October 17, 2002 18
Two Choices
• Don’t answer questions
• Pick a cut-off number or a rule for determining a cut-off number
• Pre-Enron, number was $3. Now I believe it is $10.
October 17, 2002 19
Not Feasible to Refuse to Answer
• Another dialog:
• How about $100 of equity?
• That will do it? Then how about $99?
• That’s OK, too? Then how about $98?
October 17, 2002 20
Categorizations
• Use of categories as a basis of aggregation is too handy to abandon.
• Requires methods for assigning things to categories.
• Creates the possibility of playing games to manipulate the classification.
October 17, 2002 21
Principles-Based Standards
• Some think less detailed rules are the answer.
• I think not.
• Rules for assigning things to categories fall somewhere in the following box:
October 17, 2002 22
Explicit Implicit
Uniform
Varied
Logical Possibilities for Classification Rules
October 17, 2002 23
Accounting Profession
During the recent past, however, the profession has not always lived up to its duties and responsibilities. …Because of the growing list of substandard audits, the profession is slowly losing its credibility…. We have seen too many recent instances of flawed accounting reports that simply have been chalked up to the overworked explanation that a certain amount of poor financial reporting is inevitable.
Judge Sporkin
October 17, 2002 24
Accounting Profession
We are not confronted with a liability crisis. We are instead confronted with an identity crisis. We don’t know for what, to whom, and the when of our responsibility.
Abraham Briloff
October 17, 2002 25
Profession’s Response
• Tightened internal control of Big 4
• Emergency response teams
• Pro-active – before the Public Company Accounting Oversight Board requires changes
October 17, 2002 26
You can’t regain credibilityby only doing things you arerequired to do.