More Than a Numbers Game: A Brief History of Accounting

Condensed highlights of More Than A Numbers Game

Chapter 1

• Corporate financial reporting emerged in 19th-century America when professionals applied quantitative methods to qualitative endeavors.

• Accounting quantifies business communication. Financial accounting, the primary dialect, allows lenders and investors to assess the amount, timing, and certainty of a corporation's future cash flows.

• With the passage of US income tax law, the federal government embraced accounting to measure taxable income.

• Tax accounting mutated into a system designed to determine when a taxpayer had the obligation and ability to pay tax bills. Companies then needed two sets of books.

• Scale-sensitive enterprises like steel producers and car manufacturers developed enormous infrastructures to reduce unit costs. Massive indirect costs could not be easily traced to individual products. Sophisticated companies developed allocation systems to ensure product prices recovered all resources consumed in production.

• Healthy manufacturing firms learned to keep a third set of books to refine cost accounting methods. Some regulated companies then had to file reports demonstrating solvency or compliance with government rules.

• These lucky banks, insurers, utilities, and transportation firms required a fourth set of books to maintain business licenses.

• The language of business became the province of experts. Accounting rules trace to bookkeeping practices. Masters taught apprentices and custom became precedent.

• Rules agreed upon in the United States coalesced into Generally Accepted Accounting Principles (GAAP). Not until the Great Depression did formal bodies document and propose revisions to GAAP.

• The organization to emerge as the leading force for accounting standards was the trade group representing independent auditors, the American Institute of Certified Public Accountants. Ideas put forth by accounting educators and financial statement preparers carried less weight. Economists who developed insight into the nature of capital markets, financial securities, and asset valuation garnered little respect from the auditing profession and its clients.

• What did resonate was summarization. Financial accounting proved brilliant at condensing myriad transactions into a single statistic - earnings per share or EPS - which could be shared among thousands of investors. The discipline emerged as the primary tool to communicate corporate position and performance to absentee investors and lenders. As the US economy developed over the 20th century, accounting matured to summarize increasingly complex transactions in simple terms.

• Three events tainted this maturation.
1. the need to collect income taxes and product costing information created dialects; no one stepped forward to harmonize record-keeping practices amongst the accounting's branches. The resulting lack of conformance validated a belief that there was no negative consequence for reporting the same event in varied ways.
2. The growth of services aggregating analyst earnings estimates led to a game where analysts and investors evaluated the quality of a firm's reported results by determining whether the company met or missed consensus earnings figures.
3. Statement preparers ignored advancements in economics. University researchers developed tools to understand the consequences of business transactions and reporting principles. Practitioners brushed off this work and developed misguided judgments about market behavior.

• When certain firms' stock prices became overvalued in the 1990s, these three forces combined to create a pathological fear among statement preparers of reporting volatile earnings and showing debt on the balance sheet. The resulting actions created a train wreck in 2002.

Chapter 2: Railroads

• Accounting principles turn on three concepts: recognition, valuation, and classification.

• Accounting principles value most assets at historical cost, with a downward revision if appropriate, to cover deterioration or impairment.

• Since 1894, the US convention has been to classify assets in descending order of liquidity in order to make the balance sheets more useful to creditors. Assets that could not be easily converted into cash appeared further down the balance sheet's left-hand side.

• As with assets, accountants classify liabilities in decreasing order of liquidity: payables due within 30 days appear near the top, while long-term bonds appear near the bottom.

• Debt and shareholders' equity, collectively known as capital, make up a firm's long-term financing. Bondholders and stock investors trade divisible pieces of these balances in capital markets.

• Just as historical cost represents the bedrock of asset valuation, matching is the foundation of the income statement. Instead of comparing inflows and outflows of cash, accountants use accruals to align efforts and accomplishments over an accounting period. Management estimates used to match revenues and expenses convey information valuable to investors and creditors.

• Perhaps the most important accounting decision a bookkeeper can make is determining whether resources consumed today will generate revenue in future accounting periods. If the answer is yes, then the charge should be capitalized and classified on the balance sheet as an asset. If not, then the balance should be expensed, flow through the income statement, and accumulate as a reduction in retained earnings. This issue will reappear in subsequent chapters.

• With increasing stock ownership in the 1920s, the income statement displaced the balance sheet as the primary financial statement. Lenders want to know if they will get their money back. Balance sheets show potential collateral and the existence of other claims. Shareholders care about a corporation's ability to pay future dividends through growth and improved margins. Whereas balance sheets supported creditor evaluation of management, income statements published by corporations in the early 20th century allowed equity investors to value company shares.

• Wall Street gravitated toward income from continuing operations, also frequently labeled with the non-GAAP term "operating income," as the chief indicator of future earnings power and dividend capacity by the mid-20th century. US corporate accounting's primary purpose was the computation of earnings to facilitate stock evaluation. Many investors multiplied current earnings by some valuation factor to arrive at an indicated share price. The relationship between accounting earnings and stock prices became the single most important association in US security analysis.

• During this time, financial accounting began to serve a third purpose. In the most cited journal article in the history of finance, "Theory of the Firm," Michael Jensen and William Meckling showed the interests of employee-managers and outside investors could never be completely aligned. Agency costs represent investor losses sustained when employees act in unwanted ways. Absentee ownership became synonymous with corporate America. Dispersed ownership means no individual shareholder can influence management actions, especially when management controls the proxy process for soliciting shareholder votes. Management abuses can easily arise from the institutional separation of management from ownership.

• Investors and creditors fashion contracts from financial accounting balances and attempt to align employee interests. Compensation schemes based on accounting results and bond covenants tied to earnings or debt levels were common examples. Regulators sometimes threatened intervention when reported capital levels dropped below agreed-upon solvency trigger points. Labor unions used reported earnings as a basis for contract negotiations. By the end of the 20th century, reported earnings and debt levels became very significant issues to preparers of financial statements.

Chapter 3: Taxes

• Three tenets of US tax policy have been:
1. Ability to pay
2. Equality of sacrifice
3. Imposition of burdens commensurate with government benefits received

• A corporation is a legal being. Where a partnership is a conduit to its owners, a corporation is an entity distinct from shareholders with its own records. Corporations, legislators reasoned, were fully capable of paying their own income taxes.

• In 1913, Wyoming became the 36th and last state needed to ratify the 16th amendment to the Constitution. Congress then had the power to collect taxes on income without regard to apportionment or consensus considerations.

• Financial accounting is about matching efforts and results. US tax accounting turns on the realization principle: income should not be taxed until cash is available to pay liabilities. Tax authorities permit deferral of unrealized gains until cash is received to prevent involuntary asset liquidations or borrowing to pay taxes. While there are some permanent differences between tax and GAAP income, the two accounting methods report comparable results over sufficiently long time periods.

• Ideally, management would prepare external financial reports under FIFO and tax returns under LIFO. The firm would show increasing earnings yet minimizes taxes through matching revenue with the most expensive inventory acquired. The real world is not so simple.

• This study was consistent with the argument that investors see through accounting convention. When assessing a firm's cash generating ability. The study suggested sensible managers concerned about their stock price should forsake accounting earnings to boost cash flow through the deferral of income tax payments.

• A fundamental dissonance: financial accounting's primary goal is to provide useful information to management, shareholders, creditors. Tax accounting rules, by contrast, permit the IRS to collect revenue. Financial accounting should be conservative with measurement error deliberately biased in the direction of understatement of income and assets. Tax accounting in contrast should protect the public treasury and improve the amount and timing of collections. The dissonance of tax and financial accounting objectives makes attempts to reconcile the two impossible.

Chapter 4: Costs

• Cost accounting is the one dialect where practitioners listen to outside experts such as economists and engineers.

• John Maurice Clark taught an economics course on the nature of overhead costs and published course materials. In a 1923 book, Clark studied the behavior of costs that could not be traced directly to a product. His economics training led him to tackle cost accounting problems with marginal analysis - the differential cost incurred if a course of action is taken or rejected.

1. Cost accounting differs from financial accounting. Financial accounting concerns itself with revenue and expense to calculate an absolute level of income available to pay dividends after an accounting period. Cost accounting, Clark argued, furnishes management with information needed to establish efficiency standards and pricing policies.

2. He emphasized that cost numbers are not absolute. For some decisions, they matter a great deal, while in other situations, the same costs may be irrelevant. He found that over sufficiently long horizons, infrastructure investment represents a variable cost that grows just as fast as revenue.

3. He argued that corporate structure involves the delegation of executive duties. Control ensures assigned tasks are done in intended ways. The raw materials for this process are record-keeping standards established at the home office. McKinsey viewed accounting and statistical records as the guts of management. He gave examples of recommended reports to control corporate sales, purchasing, traffic, and manufacturing functions.

• RS Edwards and Ronald Coase at the London School of Economics developed the concept of opportunity cost in business analysis. Opportunity cost represents benefits forgone from failing to dedicate a scarce resource to its best use.

• Forward-looking analysis requires opportunity costs to be estimated and considered, even though they fail to meet financial accounting recognition criteria. A common use of opportunity cost is including a firm's cost of equity capital when evaluating investment decisions. Equity does not generate an accounting charge under GAAP, but this valuable resource has other possible uses. Cost accountants properly exclude sunk costs from forward-looking analysis because no management action affects their value.

• The Inuit language apparently provides Eskimos with dozens of words for snow; cost accountants use many descriptors for resource consumption. Costs can be fixed, variable, normalized, actual, imputed, sunk, direct, indirect, controllable, uncontrollable, and so on. Granularity brings precision.

• Experts' next intellectual contribution to cost accounting was the use of present value analysis. Investments involve time delays between outlays and returns. Actuarial literature had discussed the time value of money since the early 1800s, but it wasn't until the 1950s that engineering consultants applied this tool to compare certain cash disbursements with risky future receipts. The petroleum industry, with enormous exploration and production investments, was an early adopter of this tool.

• Every control system brings unintended consequences. People react to incentives in ways not contemplated by the system's designers. Engineers use the term suboptimization to describe the mindless pursuit of one goal to the detriment of a broader organizational interest. In 1992, a famous article “The Balanced Scorecard”, by Harvard Business School Professor Robert Kaplan and Massachusetts consultant David Norton, sought to address this problem. The authors likened the management information system to an airplane cockpit’s instrument cluster. Pilots need a holistic view of operating performance to keep the plane flying as intended, and a well-defined control system reduces critical variables to a handful of measures that can be understood by all.

• Balanced scorecards should consider customer perspectives, internal processes, innovation, as well as customary financial metrics. The authors argued that traditional management accounting systems, sprung from finance functions to control behavior, fit the industrial age’s engineering mentality, whereas balanced scorecards that give primacy to strategy and vision are suited to the kinds of organizations many companies are trying to become in the information age.

Chapter 5: Disclosure

• Financial accounting emerged as a tool that allowed distant creditors to monitor the management's stewardship of corporate assets. With the rise of equity ownership in the United States during the early 20th century, investors began to use financial accounting for a second purpose – the valuation of shares. It's not clear that financial accounting was ever designed to aid investors in the forecasting of future earnings and cash flows. Nevertheless, financial accounting's ability to summarize myriad numbers into a handful of statistics proved alluring to stock investors.

• Through the 1934 act that created the SEC, Congress granted it the authority to prescribe financial accounting principles and specify the form and content of financial statements. In one word, the SEC is about disclosure. The SEC also sought to narrow the diversity of accounting practices. The SEC gave itself the power to approve financial statements instead of just requiring their disclosure. Perhaps the best-known part of the 1934 Act was prohibiting company officers from buying or selling their employer’s securities while in possession of material non-public information.

• The investing public came to associate outside auditors with the accounting profession. Annually, the Master of Ceremonies at the Academy Awards introduced the Price Waterhouse partner responsible for tabulating votes.

Chapter 6: Standards

• [Kris: This chapter is concerned with efforts to make accounting approaches uniform for easier comparison, highlighting the tensions of who accounting rules serve. There is always discretion and debate, and short-term winners and losers, even if the cash flow should be unaffected in the long term.]

• A 1973 report concluded that financial statements provide useful information for decision making. Perhaps the most important information was that which helped investors and creditors predict the amount, timing, and certainty of a corporation's future cash flows. The report acknowledged that no one really knew how investors and creditors use accounting information to make these assessments.

• [Kris: This sounds like an argument against strict uniformity while confirming the general value of reporting.]

• Immediately after its creation, the FASB embarked on a 20-year, multi-million dollar Conceptual Framework initiative to anchor US financial accounting standards in defensible principles. Yet, the FASB learned early on that it serves at the pleasure of the SEC, a federal administrative agency created by Congress. Politicians serve constituents, not theories.

• The APB and FASB received the same message from the federal government: Reduce diversity of practice without alienating constituents. The fact that the selection of most accounting principles makes no difference over the long run held no sway in politics.

Chapter 7: Science

• An implication of the EMH and related statistical research was that financial accounting standards do not matter. Investors in aggregate review all sorts of accounting and non-accounting data to divine company prospects. As shown with the LIFO controversy, there is considerable evidence that investors see through accounting form. Well-functioning capital markets may not need strict conformance with clearly articulated financial accounting rules. If investors were indeed slaves to accounting income, a few bright analysts could earn enormous trading profits after making adjustments for cosmetic accounting standards. No one has yet found a way to do this.

• However, the EMH may not be sufficient to discipline these managers if they hold incorrect beliefs about investor behavior.

• "Sorry, I understand cash flow trumps accounting earnings, but those naive investors do not. I'll make accounting choices that give them earnings trajectories they think they want."

• Critics of CAP and the APB had charged that these bodies had promulgated financial accounting standards in the absence of guiding principles. Bulletins represented ad hoc fixes while academic attempts to fashion accounting postulates gathered dust.

• The FASB sought a foundation to support its statements. The resulting Conceptual Framework became the largest, most expensive effort ever undertaken to document a theory of financial reporting. The seven statements of financial accounting concepts published over 22 years consumed untold millions of dollars and man-hours to produce at the time of this writing. The Conceptual Framework stands as the reigning champion of accounting theory. This work represents the best effort put forth by standard setters to craft a science of accounting. The framework does not codify accounting rules, a task that has proven impossible to date. Instead, the framework offers principles the FASB has increasingly used to frame financial accounting debates.

• At the end of the day, a humble accountant must decide whether to recognize a transaction in an accounting period, what dollar amount to assign to that item, and where in the financial statements that item should appear. Economic research has helped predict how accounting practices affect security prices, but this science is yet to tell a bookkeeper what to do.

Chapter 8: Inflation

• The issue of inflation accounting is the first instance where academics were able to apply science to resolve a financial accounting debate. This chapter serves as a case study of what could happen if academics and practitioners communicate more effectively.

• Tactically, the inflation accounting experiment failed. Users did not find restated balances relevant or reliable. In addition, LIFO inventory accounting provided only a partial solution because inventory costs remaining on the balance sheet became increasingly out of date.

• Strategically, the debate shows that academics could help statement preparers resolve a financial accounting dispute.

Chapter 9: Volatility

• The second seminal event in the history of corporate finance was the development of the capital asset pricing model. However, financial statement preparers paid little attention to this groundbreaking concept. Consequently, corporate management did not overcome an ill-conceived fear of reporting volatile earnings.

• While working at the RAND Corporation, William Sharpe met Economist Harry Markowitz. Markowitz's famous 1952 paper, “Portfolio Selection,” showed that diversification reduces risk. However, Markowitz struggled to pinpoint how the correlation among returns of individual holdings influences aggregate portfolio risk.

• The required return, also known as the cost of equity, represents expected earnings needed to attract equity capital for a particular investment. This forward-looking measure depends on investor sentiment and cannot be observed directly.

• Sharpe published the Capital Asset Pricing Model in 1964. Sharpe, Markowitz, and Merton Miller shared a Nobel Prize in 1990 for laying the foundation of modern financial economics. Sharpe argued that the investment risk of a given stock is not about raw volatility. Investors face risks that can and cannot be eliminated through diversification. Buyers of financial instruments demand to be compensated for systematic risk resulting from swings in economic activity. They are less concerned with idiosyncratic risk.

• A major hurricane could cause substantial damage to homes in Miami. A local property insurer faces ruin. Financial markets will not punish this firm with exorbitant equity costs. Potential investors can diversify by holding shares in a lumber company that would see sales rise in the event of a major windstorm. The presence or absence of a hurricane would little influence combined returns of both securities.

• Problems with reporting volatility have caused tension between standard setters and statement preparers since the 1930s. Managers believe investors consider bumpy earnings a blemish when evaluating a firm's earnings power; by contrast, standard setters want companies to tell it like it is, alerting outsiders to the presence of warts on a corporate earnings trajectory.

• Three case studies illustrate this tension:
1. Currency translation
2. Accounting for the value of defined benefit pensions which depend on interest rates and are long-duration liabilities
3. The valuation of financial securities held in corporate portfolios

Chapter 10: Intangibles

• Financial Accounting evolved from a means to monitor

• Intangible assets represent those invisible resources such as brand, culture, customer lists, and process knowledge that help companies grow profitably. These amorphous tools often cannot be bought or sold independently of the company itself.

• By 2000, intangible resources came to be recognized as the only significant corporate asset class worth acquiring. Most receivables, inventory, machinery, and land can be replaced easily.

• In 2002, Microsoft's total recorded intangible assets represented just less than 1% of the company's market value but the accounting problem with intangible assets is not relevance but reliability.

• In 1944, CAP distinguished:
1. Purchased intangibles from those developed internally
2. Those with finite lives (patents and licenses) from those with indefinite lives (goodwill and perpetual franchises).

• There was no guidance for valuing internally developed intangibles.

• In 1974, the FASB put forth the most concise standard in US GAAP: All research and development costs encompassed by this statement shall be charged to expense when incurred.

• In 1985, the FASB decided to expense all R&D but then established an exception for software development.

• Spring loading? (the case of IBM buying Lotus 1 2 3) — Taking a large one-time charge that helps a firm show subsequent earnings growth after new management comes to power.

• In 2001, standard setters once again did not address accounting for internally developed intangibles. The focus was on intangibles acquired through purchase or merger. Instead of concluding that all intangibles are wasting assets with finite lives, the new standard concluded that goodwill and other intangibles have indefinite lives and should not be amortized arbitrarily. They should be tested for impairment at least annually, and any identified impairment should be charged to income.

• To this day, standard setters have not determined how to value internally developed intangible assets other than software.

• Case of AOL
• AOL spent heavily to grow a subscriber base quickly. Publicly traded firms needing more financing feel enormous pressure to report consistent profits. Bill Sharpe’s arguments about diversifiable risk mean little to aspiring corporate treasures.
• AOL capitalized acquisition costs on the balance sheet and amortized them over 24 months. If AOL had expensed them, it would have reported losses. Literally, accountants would shy away from capitalizing intangible asset development costs because it is hard to match these costs with uncertain future revenues.
• AOL grew through a series of remarkably bold acquisitions. Its soaring stock price created a currency to buy significant companies. When it eventually bought Time Warner, one critic described it as “one company without assets buying another one without a clue”. Nearly 2/3s of AOL's assets were goodwill.
• (AOL would eventually agree to a $3.5 million fine to restate 1995 and 1996 earnings.)
• In 2002, Corporate America paid the price for its 1990s acquisitions binge. It recognized $140 billion of intangible write-offs, a sum equal to the write-offs of the prior eight years.

Chapter 11: Debt

• Practitioners showed little interest in the efficient markets hypothesis. As a consequence, many statement preparers believed that outside creditors and investors could be fooled by the optics of financial statement presentation. The form of a balance sheet could seemingly trump economic substance when analysts evaluated a company's health. This belief manifested itself most clearly in accounting for debt on the balance sheet. The presence of debt came to be viewed as a sign of corporate weakness. Management teams pushed standard setters to permit companies to keep debt off the balance sheet presentation.

• The fraction of a firm's asset base financed through liabilities is perhaps the most significant issue in corporate finance.

• Since 1894, the US tax code has permitted interest expense deductions when computing a corporation's taxable income. However, the tax code makes no such provision for dividend distributions to investors. The deductibility of interest makes a firm's capital structure, the share of long-term financing allocated between debt and equity, a determinant of firm value. Some debt gives the firm protection against income taxes, but too much exposes the firm to bankruptcy.

• The tension: Debt financing provides a tax shield and allows capital providers to retain a greater share of the firm's earnings. Substituting debt for equity reduces the number of shares outstanding and raises EPS. Some believe that this further enhances firm value because the discipline required to repay borrowings deters ill-conceived investments but the prospect of financial distress causes lenders to worry that owners could act counter to creditors' interests. Shareholders of overly leveraged firms may salvage positions at the expense of bondholders. Tactics include declaring large cash dividends and leaving fewer assets to lenders in the event of a liquidation, issuing even more debt, which makes old debt riskier and less valuable; selling valuable assets which leaves creditors less collateral to back their loans; or swinging for the fences with risky investments.

Chapter 12: Options

• The third significant idea in the history of finance was the development of the Black-Scholes option pricing model. This chapter describes how compensation with options replaced debt as a governance tool in the 1990s.

• The Black-Scholes model allowed accountants to resolve a long-standing debate, yet practitioners remained slow to embrace this tool. Corporations did not charge option-based compensation expenses to income statements. Financial accounting thus enabled some corporate boards to make outlandish use of this compensation tool.

• Academics spent decades trying to solve the problem of option valuation.
• In 1933, two Columbia professors stated that option contracts had not been traded long enough to permit the formation of any intelligent judgment of their value.
• A legal scholar in 1953, concerned with the decline in real purchasing power for executives from 1939 to 1951, thought stock options would be a tax-efficient means of restoring executive pay, but he was concerned there was no realistic method of arriving at a dollar value for an option.
• An accounting theorist in 1970 acknowledged there was no definitive way to value options. Even Paul Samuelson and Robert Merton could not find a general solution.
• Accounting bodies had wrestled with option valuation since the 1940s, especially within the context of compensation.

• In the spring of 1973, the CBOE opened for business and the May-June issue of the Journal of Political Economy published the “Pricing of Options and Corporate Liabilities” by economists Fisher Black and Myron Scholes, who resorted to stochastic calculus and physics heat transfer equation to solve the problem.

• The use of options in executive compensation gained momentum after a 1993 revision to the IRS code, which disallowed deductions for annual salaries greater than $1 million paid to CEOs of publicly traded firms and its four other most highly compensated executive officers. Beginning in 1994, any compensation over the million-dollar limit had to be performance-based to qualify for a tax deduction. Stock options became the tool of choice to satisfy this condition.

• From 1985 to 1997, stock option awards increased tenfold. From 1970, CEO pay averaged 39 times an average worker's salary, increasing to 1,000 times by 1999.

• In 1993, the FASB concluded that options have measurable extrinsic value, which should be charged to expense over an appropriate vesting period. The following year, 3,000 people met at the San Jose Convention Center to protest the proposal. Stock option accounting became so divisive that it threatened the board's future working relationship with some of its constituents. While the board stated unequivocally that options have a value that can be estimated by option pricing models, it only required that firms disclose proforma earnings as if they had used the option models.

• The FASB allowed the disclosure alternative to bring closure to the debate, not because it believed that the solution was the best way to improve financial reporting. Arthur Levitt admitted that urging the FASB to back off from its proposal to expense options was the “biggest mistake I made as SEC chairman.”

• By December 2004, the FASB required companies to value option grants with pricing models and charge this sum to earnings over appropriate service periods.

• The case study of options accounting shows management's continued preoccupation with reported earnings and disdain for economic research. Unfavorable financial disclosures came before awards, which a senate could argue depress stock prices and increase the number of options granted for a given dollar value of variable compensation. Good news was disclosed after awards to prevent a run-up in the stock price and reduction in the number of options granted for a fixed dollar award.

• When offered academic evidence at an FASB hearing that the stock market shrugs off accounting adjustments, the Home Depot chairman snapped, “You're trying to confuse me with logic here, it's not going to work. I deal with the emotional side of the street. I deal with Wall Street.” No amount of science could convince this manager that financial markets are reasonably efficient.

• Research confirmed academic intuition. There was no significant consequence of expensing options on company stock prices. The results were consistent with the University of Chicago studies that markets see through accounting window dressing when valuing securities.

Chapter 13: Earnings

• Previous chapters showed that statement preparers did not pay much attention to the Efficient Markets Hypothesis, Capital Asset Pricing Model, and Black Scholes option evaluation model. Therefore, some management teams believe that:
1. Investors could be fooled by financial statement presentation.
2. Reporting volatile earnings was a sign of weakness.
3. Option awards had little cost.

• Consequently, it is not surprising that management at many companies became obsessed with using accounting tools to meet quarterly targets to boost stock prices and inflate the value of option awards.

• Earnings represent the single most important item in a corporate financial report. Over a 1 to 10-year horizon, stock returns appear to be explained overwhelmingly by a firm's cumulative earnings during the period. The explanatory power of other possible metrics like dividends, cash flows, and capital expenditures pales in comparison.

• The ultimate measure of corporate success in the 1990s was producing a long, consistent earnings trajectory. Rational managers, trying to impress outside observers, routinely met or beat consensus numbers by a small amount. Earnings coming in well above a threshold would simply cause outsiders to raise the bar further.

• Of course, all businesses mature. None can grow faster in perpetuity than the US economy; otherwise, that firm becomes the US economy. Corporations that choose to smooth earnings can get into trouble towards the end of the business life cycle. Management must come up with increasingly heroic assumptions to meet ever higher earnings targets extrapolated from a linear trend.

• Extreme pressure to produce earnings growth was a 1990s phenomenon. Managers in the 1920s, working at a time of the previous great stock level, felt no such pressure. Contemporary investors did not demand steady year-to-year earnings increases. Rising managers received less frequent promotions or transfers. Executives came from technical and manufacturing ranks and turned to operations, not accounting, to create wealth. A study of earnings released from 1947 through 1966 suggested that period to period movement in earnings was random, even though earnings-based executive compensation emerged in the 1950s.

• The tone changed in the 1990s with the success of blue-chip firms such as General Electric. By 1998, SEC chairman Arthur Levitt bemoaned that accounting had become a “numbers game” where management suppressed common sense business practices, satisfied consensus earnings estimates, and projected a smooth earnings path in an attempt to grow a company's stock and the value of their underlying options.

• The EPS bubble burst when accounting scandals came to light at the turn of the millennium. What seems to have been occurring was a game in which analysts and investors were testing the quality of a company's stated earnings by determining whether management could hit its targets. This odd game of inferences created the strange market phenomenon in which companies that missed their earnings by a penny or two saw 20 to 30% declines in their share prices. Reported earnings became important because management actions made them so important!

• A parallel story to the EPS drama was the rise of pro forma earnings. Technology firms in the 1990s issued press releases featuring pro forma earnings figures in addition to earnings prepared under GAAP. Telecom companies' enormous infrastructure investments saddled earnings with large depreciation charges. Management chose to focus investor attention on earnings before interest, taxes, depreciation, and amortization. Warren Buffett poked fun at this practice of EBITDA.

• However, researchers compared stock prices and earnings data for companies that did and did not report pro forma numbers. They found little difference in stock price behavior. In other words, investors did not appear to price shares of firms issuing pro forma earnings differently from those disclosing only GAAP numbers.

Epilogue

• Discretion invited trouble.

• We learned that the act of observation disturbed the subject. The more importance users attach to accounting figures, the less comfort users can take in their reliability.

• Research related to EMH suggested investors eventually see through gimmicks when setting security prices. They do not necessarily punish raw earnings volatility, and acceptance of option pricing models may have led to expensing of grants and more intelligent use of this incentive tool.

• Today's financial accounting issues will continue into the future. The resources spent to create a conceptual framework will likely show little benefit. Accounting will remain a pragmatic tool full of idiosyncrasies. Well-crafted principles will not solve these problems either, based on studies of pooled interests, leases, and lost contingencies.

• And finally, no control system can ever guard completely against bad management behavior. The only workable solution is for corporations to select CEOs with impeccable integrity.

Full Notes

Chapter 1

Corporate financial reporting emerged in 19th-century America when professionals applied quantitative methods to qualitative endeavors.

Accounting quantifies business communication. Financial accounting, the primary dialect, allows lenders and investors to assess the amount, timing, and certainty of a corporation's future cash flows.

With the passage of US income tax law, the federal government embraced accounting to measure taxable income.

Tax accounting mutated into a system designed to determine when a taxpayer had the obligation and ability to pay tax bills. Companies then needed two sets of books. Scale-sensitive enterprises like steel producers and car manufacturers developed enormous infrastructures to reduce unit costs. Massive indirect costs could not be easily traced to individual products. Sophisticated companies developed allocation systems to ensure product prices recovered all resources consumed in production.

Healthy manufacturing firms learned to keep a third set of books to refine cost accounting methods. Some regulated companies then had to file reports demonstrating solvency or compliance with government rules.

These lucky banks, insurers, utilities, and transportation firms required a fourth set of books to maintain business licenses.

The language of business became the province of experts. Accounting rules trace to bookkeeping practices. Masters taught apprentices and custom became precedent. Rules agreed upon in the United States coalesced into Generally Accepted Accounting Principles (GAAP). Not until the Great Depression did formal bodies document and propose revisions to GAAP.

The organization to emerge as the leading force for accounting standards was the trade group representing independent auditors, the American Institute of Certified Public Accountants. Ideas put forth by accounting educators and financial statement preparers carried less weight. Economists who developed insight into the nature of capital markets, financial securities, and asset valuation, garnered little respect from the auditing profession and its clients.

What did resonate was summarization. Financial accounting proved brilliant at condensing myriad transactions into a single statistic - earnings per share or EPS - which could be shared among thousands of investors. The discipline emerged as the primary tool to communicate corporate position and performance to absentee investors and lenders. As the US economy developed over the 20th century, accounting matured to summarize increasingly complex transactions in simple terms.

Three events tainted this maturation.

1. the need to collect income taxes and product costing information created dialects no one stepped forward to harmonize record-keeping practices amongst the accounting's branches. The resulting lack of conformance validated a belief that there was no negative consequence for reporting the same event in varied ways

2. The growth of services aggregating analyst earnings estimates led to a game where analysts and investors evaluated the quality of a firm's reported results by determining whether the company met or missed consensus earnings figures.

3. Statement preparers ignored advancements in economics. University researchers developed tools to understand the consequences of business transactions and reporting principles. Practitioners brushed off this work and developed misguided judgments about market behavior.

When certain firms' stock prices became overvalued in the 1990s, these three forces combined to create a pathological fear among statement preparers of reporting volatile earnings and showing debt on the balance sheet. The resulting actions created a train wreck in 2002.

Accounting principles turn on three concepts: recognition, valuation, and classification.

Accounting principles value most assets at historical cost with a downward revision if appropriate to cover deterioration or impairment.

Since 1894, the US convention has been to classify assets in descending order of liquidity in order to make the balance sheets more useful to creditors. Assets that could not be easily converted into cash appeared further down the balance sheet's left-hand side.

As with assets, accountants classify liabilities in decreasing order of liquidity: payables due within 30 days appear near the top while long-term bonds appear near the bottom.

Debt and shareholders' equity, collectively known as capital, make up a firm's long-term financing. Bondholders and stock investors trade divisible pieces of these balances in capital markets.

Just as historical cost represents the bedrock of asset valuation, matching is the foundation of the income statement. Instead of comparing inflows and outflows of cash, accountants use accruals to align efforts and accomplishments over an accounting period. Management estimates used to match revenues and expenses convey information valuable to investors and creditors.

Perhaps the most important accounting decision a bookkeeper can make is determining whether resources consumed today will generate revenue in future accounting periods. If the answer is yes, then the charge should be capitalized and classified on the balance sheet as an asset. If not, then the balance should be expensed, flow through the income statement, and accumulate as a reduction in retained earnings. This issue will reappear in subsequent chapters.

With increasing stock ownership in the 1920s, the income statement displaced the balance sheet as the primary financial statement. Lenders want to know if they will get their money back. Balance sheets show potential collateral and the existence of other claims. Shareholders care about a corporation's ability to pay future dividends through growth and improved margins. Whereas balance sheets supported creditor evaluation of management, income statements published by corporations in the early 20th century allowed equity investors to value company shares.

Wall Street gravitated toward income from continuing operations, also frequently labeled with the non-GAAP term operating income, as the chief indicator of future earnings power and dividend capacity by the mid 20th century. US corporate accounting's primary purpose was the computation of earnings to facilitate stock evaluation. Many investors multiplied current earnings by some valuation factor to arrive at an indicated share price. The relationship between accounting earnings and stock prices became the single most important association in US security analysis.

During this time, financial accounting began to serve a third purpose. In the most cited journal article in the history of finance, "Theory of the Firm," Michael Jensen and William Meckling showed the interests of employee-managers and outside investors could never be completely aligned. Agency costs represent investor losses sustained when employees act in unwanted ways. Absentee ownership became synonymous with corporate America. Dispersed ownership means no individual shareholder can influence management actions, especially when management controls the proxy process for soliciting shareholder votes. Management abuses can easily arise from the institutional separation of management from ownership.

Investors and creditors fashion contracts from financial accounting balances and attempt to align employee interests. Compensation schemes based on accounting results and bond covenants tied to earnings or debt levels were common examples. Regulators sometimes threatened intervention when reported capital levels dropped below agreed-upon solvency trigger points. Labor unions used reported earnings as a basis for contract negotiations. By the end of the 20th century, reported earnings and debt levels became very significant issues to preparers of financial statements.

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Claude Summary

• Accounting emerged in 19th century America as professionals applied quantitative methods to qualitative endeavors.

• Financial accounting allows lenders and investors to assess future cash flows.

• Tax accounting mutated into a system to determine when taxpayers had obligation and ability to pay bills. Companies needed multiple sets of books.

• Large companies developed sophisticated allocation systems to ensure prices recovered all production costs.

• By the end of the 20th century, reported earnings and debt levels became very significant issues for preparers of statements.

Chapter 2: Railroads

In the absence of accounting information, some investors looked at dividend payment rates. Cash can be a simple, visible, and credible indicator of operating health. However, dividends represent an imperfect signal because firms could dip into contributed capital when current earnings were insufficient to cover distributions.

Management duplicity could cause investors to confuse return of capital for return on capital. Concealment of losses represents the essence of accounting scandal. These actions cause investors to pay high stock prices for ventures that could not sustain large dividend payments. Early corporation laws developed to forbid dividend payments from contributed capital, requiring distributions to come from retained earnings.

Bondholders turned to credit reporting firms to assess a railroad's ability and willingness to repay debt. Henry Poor and John Moody began rating railroad bonds in the 1910s. They merged with Standard Statistics in 1941 to become Standard and Poor's. Investors sought even more information to assess corporate performance. Enlightened managers simultaneously sought to reduce investor anxiety. Financial accounting emerged as a communication tool to meet both ends since nascent reporting practices could not provide all the information investors sought. European investors favored lower-risk debt instead of equity securities.

The first auditing firms emerged from the need to audit railroad corporations. Not until the age of railroads did accountants formally consider depreciation. What distinguished railroads was the scope of the fixed assets. A critical lesson is that net income over a sufficiently long time equals cash inflows minus cash outflows other than transactions with owners. In this example, regardless of depreciation assumptions made, the locomotive generates $35,000 of income over its 5-year life. Accounting principles do not affect the corporation's cash flows. Depreciation merely reflects the arbitrary cost allocated into accounting periods. Depreciation assumptions and most other accounting disputes matter little in the long-term course of business. Few early statement preparers and users argued about depreciation. The concept was largely ignored until the 1909 corporate income tax law permitted a deduction for depreciation charges in the calculation of taxable income.

At the beginning of the 20th century, some managers began to use depreciation to smooth reported earnings. A 1912 Journal of Accountancy editorial complained that depreciation had become a tool used by management to counter fluctuations in profits. Good years had been made to bear heavy charges. Bad years bore no provision or an inadequate one.

In 1906, the Hepburn Act gave the Interstate Commerce Commission the power to establish maximum shipping rates and required railroads to adopt uniform accounting practices.

Accounting rules resulting from the Hepburn Act were the first in US history that could be enforced by federal law under penalty of fine or imprisonment for lack of compliance.

Other federal regulatory bodies such as the Federal Power Commission and the Federal Communications Commission subsequently emerged to set industry-specific accounting guidelines to promote interfirm financial comparisons and regulate prices.

On March 12th, 1903, US Steel published consolidated financial statements as of December 31st, 1902, together with PricewaterhouseCoopers' assurance that they were audited and found correct. Managing partner Arthur Lowes Dickinson insisted US Steel present consolidated statements showing assets and liabilities of all subsidiaries instead of just the parent company's accounts. The era of modern financial accounting had dawned.

Chapter 3: Taxes

Practitioners struggled to reconcile the conflicting purposes of tax and financial accounting.

The 1862 Union government established the Bureau of Internal Revenue to assess personal and corporate income taxes to help finance the civil war. The federal government allowed the measure to expire in 1872.

By the mid 1890s, corporations had replaced partnerships as the country's primary form of business association. Railroad success created some extremely rich shareholders. However, corporate efficiency, depressed farmerss' commodity prices and land values and prevented craftsman from competing and scale sensitive industries.

In 1893, the US economy suffered another depression in the federal government needed revenue to cover the tax shortfall. Hired tariffs would help domestic manufacturers but place a greater burden on the common man. A collection of Democrat and populist legislators seized on a corporate income tax is a fair means of shifting the tax burden. The Revenue Act of 1894 provided for a flat 2% tax on corporate profits.

Three tenets of US tax policy have been

1. ability to pay

2. equality of sacrifice

3. imposition of burdens commensurate with government benefits received

A corporation is a legal being. Where a partnership is a conduit to its owners, a corporation is an entity distinct from shareholders with its own records. Corporations, legislators reasoned were fully capable of paying their own income taxes.

In 1913, Wyoming became the 36th and last state needed to ratify the 16th amendment to the Constitution. Congress then had the power to collect taxes on income without regard to apportionment or consensus considerations.

Financial accounting serves the needs of untold numbers of investors, creditors and analysts. Federal income tax accounting serves just one user – the IRS. The IRS deals directly with more people than any other organization in the United States. It conducts financial transactions each year with virtually every adult and business while financing 95% of the federal government activity.

Another contrast with GAAP accounting is use of the US court system to resolve tax disputes. Unhappy taxpayers may avail themselves to district courts or specialized US tax courts. The appellate process can go all the way to the US. Supreme Court management. Investors and auditors have no such forum for resolving financial accounting disagreement.

Taxation makes the government an involuntary partner to a business enterprise. Taxes reduce a firm's value to shareholders. Management thus has a fiduciary obligation to shareholders to consider tax consequences of business decisions. Financial accounting is about matching efforts and results.  US tax accounting turns on the realization principle: income should not be taxed until cash is available to pay liabilities. Tax authorities permit deferral of unrealized gains until cash is received to prevent involuntary asset liquidations or borrowing to pay taxes. While there are some permanent differences between tax and GAAP income, the two accounting methods report comparable results over sufficiently long time periods.

In the interim, very definitions of income give rise to timing differences between gap and tax statements. Accountants develop the concept of deferred tax assets and liabilities to reconcile four broad categories of timing differences.

1. Transactions involving a cash receipt before GAAP revenue recognition or expenses recognized before cash disbursement create deferred tax assets.

2. Transactions involving revenue recognized before cash is received give rise to deferred tax liabilities.

Financial accountants have long argued how to recognize value and classify tax related timing differences.

1967: Accrual accounting had reached its high water mark in the United States. The APB was more interested in matching revenues with expenses than in achieving clarity among balance sheet accounts.

1987: disenchantment with this view lead to a new view that explicitly labeled deferred tax items as assets and liabilities, these balances represent sums that will be eventually recovered or paid. A notable difference between the two rules concern accounting for tax loss carry forwards if a firm reported a tax loss but was highly likely to report profit in future years. Under the old opinion, it could record an asset for the expected tax refund. Since the loss would be applied against income in future tax years, the new stance disallowed recognition of such an asset… this sequence of events shows how a layperson could become frustrated with the financial accounting standard s setting process. Vacillation signaled lack of conviction of what financial accounting standard setters were trying to accomplish.

Tax accounting for inventory provided academics with a case study on the significance of financial accounting policies. In periods of rising prices, LIFO statements release more inventory dollars from the balance sheet to the income statement. Assuming inventory levels stay the same or grow LIFO results in lower reported earnings later tax repayments and closer matching a revenues with inventory replacement costs.

Unfortunately, LIFO uses use over long periods of inflation causes less realistic valuation of inventory. Early LIFO adopters still have inventory valued at costs prevailing during WWII. Depletion of inventory at old costs known as LIFO layer liquidation can cause spikes of artificially high earnings. If management's goal is to report increasing earnings during periods of rising prices, then it should use FIFO. If management seeks to defer taxes and conserve cash then it should use LIFO.

Ideally, management would prepare external financial reports under FIFO and tax returns under LIFO. The firm would show increasing earnings yet minimizes taxes through matching a revenue with the most expensive inventory acquired. The real world is not so simple.

The conformity rule: In 1939, the tax code allowed taxpayers to calculate taxable income using LIFO if the taxpayer has not used any other inventory valuation procedure for "credit purposes or for the purpose of reports to shareholders"

Adoption of lifo came slowly. Consistent with a fashion models mantra that it's better to look good than feel good. Corporations seem to reticent to sacrifice GAAP earnings in order to save tax dollars. In fact, some adopters encountering financial distress abandoned LIFO presumably to boost reported earnings and avoid violating accounting based debt covenants. In 1970, Chrysler switched back from LIFO to FIFO and recognized a 53 million favorable cumulative effect from the accounting change.

In 1975 Shyam Sunder, a Carnegie Mellon PhD, who had joined the University of Chicago published a study of stock price changes associated with firms that adopted LIFO during the period 1946 to 1966. Using sophisticated statistical techniques he found evidence of abnormal stock pricing increases during the 12-month period preceding LIFO adoption. An interpretation of these data is that investors rewarded firms expecting to pay lower taxes from the anticipated conversion to LIFO.

This study was consistent with the argument that investors see through accounting convention. When assessing a firm's cash generating ability. The study suggested sensible managers concerned about their stock price should forsake accounting earnings to boost cash flow through the deferral of income tax payments. Later studies provided supporting and confounding evidence of Sunder's conclusions. Getting meaning from security price movements is a tricky business.

During periods of high inflation manufacturers failure to adopt LIFO puzzled researchers one could argue FIFO users were more interested in reporting high earnings than conserving cash tax payments.

The principal of conservatism in the presence of uncertainty:  it is better to err on the side of reporting low asset values and income numbers. All accounting estimates are wrong. Overstatement of profits and asset values can give rise to actions resulting in bankruptcy. Understatement represents the lesser evil because subsequent adjustments merely provide fortuitous valuation gain.

A fundamental dissonance: financial accountings primary goal is to provide useful information to management, shareholders, creditors. Tax accounting rules by contrast permit the IRS to collect revenue. Financial accounting should be conservative with measurement error deliberately biased in the direction of understatement of income and assets. Tax accounting in contrast should protect the public treasury and improve the amount and timing of collections. The dissonance of tax and financial accounting objectives makes attempts to reconcile the two impossible.

Chapter 4: Costs

Cost accounting reports assist managers in decision-making. In recent years, the term management accounting has replaced the term cost accounting. Cost systems aim to detect or prevent problems. No control system can eliminate both type 1 and type 2 errors. The most basic control is the segregation of duties - decision-making and record-keeping responsibilities should rest with different people.

Cost accounting predates financial reporting in the United States, with textile manufacturers in the early 1800s. During the 1850s, railroads pioneered modern management. Railroads were the first high fixed-cost businesses; cost accounting tools gave rise to operating measures such as cost per ton-mile.

19th-century corporate giants focused on a single line of business, using scale and information to drive down manufacturing and distribution costs. Around 1900, a merger wave created large, complex organizations offering varied products.

By 1925, the development of management accounting stalled. Relevance Lost's authors concluded that at this point, American industrial firms had developed virtually every management accounting procedure known for the next 60 years.

Cost accounting is the one dialect where practitioners listen to outside experts such as economists and engineers. John Maurice Clark taught an economics course on the nature of overhead costs and published course materials. In a 1923 book, Clark studied the behavior of costs that could not be traced directly to a product. His economics training led him to tackle cost accounting problems with marginal analysis - the differential cost incurred if a course of action is taken or rejected.

1. Cost accounting differs from financial accounting. Financial accounting concerns itself with revenue and expense to calculate an absolute level of income available to pay dividends after an accounting period. Cost accounting, Clark argued, furnishes management with information needed to establish efficiency standards and pricing policies.

2. He emphasized that cost numbers are not absolute. For some decisions, they matter a great deal, while in other situations, the same costs may be irrelevant. He found that over sufficiently long horizons, infrastructure investment represents a variable cost that grows just as fast as revenue.

3. He argued that corporate structure involves the delegation of executive duties. Control ensures assigned tasks are done in intended ways. The raw materials for this process are record-keeping standards established at the home office. McKinsey viewed accounting and statistical records as the guts of management. He gave examples of recommended reports to control corporate sales, purchasing, traffic, and manufacturing functions.

During this time, economists RS Edwards and Ronald Coase at the London School of Economics developed the concept of opportunity cost in business analysis. Opportunity cost represents benefits forgone from failing to dedicate a scarce resource to its best use.

Forward-looking analysis requires opportunity costs to be estimated and considered, even though they fail to meet financial accounting recognition criteria. A common use of opportunity cost is including a firm's cost of equity capital when evaluating investment decisions. Equity does not generate an accounting charge under GAAP, but this valuable resource has other possible uses. Cost accountants properly exclude sunk costs from forward-looking analysis because no management action affects their value.

The Inuit language apparently provides Eskimos with dozens of words for snow; cost accountants use many descriptors for resource consumption. Costs can be fixed, variable, normalized, actual, imputed, sunk, direct, indirect, controllable, uncontrollable, and so on. Granularity brings precision.

Experts' next intellectual contribution to cost accounting was the use of present value analysis. Investments involve time delays between outlays and returns. Actuarial literature had discussed the time value of money since the early 1800s, but it wasn't until the 1950s that engineering consultants applied this tool to compare certain cash disbursements with risky future receipts. The petroleum industry, with enormous exploration and production investments, was an early adopter of this tool.

Cost accounting merely adjusts the allocation of known costs and does not affect the quantities of resources consumed, but it is more insightful and leads to better decisions.

Every control system brings unintended consequences. People react to incentives in ways not contemplated by the system's designers. Engineers use the term suboptimization to describe the mindless pursuit of one goal to the detriment of a broader organizational interest. In 1992, a famous article “The Balanced Scorecard”, by Harvard Business School Professor Robert Kaplan and Massachusetts consultant David Norton, sought to address this problem. The authors likened the management information system to an airplane cockpit’s instrument cluster. Pilots need a holistic view of operating performance to keep the plane flying as intended, and a well-defined control system reduces critical variables to a handful of measures that can be understood by all.

Balanced scorecards should consider customer perspectives, internal processes, innovation, as well as customary financial metrics. The authors argued that traditional management accounting systems, sprung from finance functions to control behavior, fit the industrial age’s engineering mentality, whereas balanced scorecards that give primacy to strategy and vision are suited to the kinds of organizations many companies are trying to become in the information age.

Chapter 5: Disclosure

Financial accounting emerged as a tool that allowed distant creditors to monitor the management's stewardship of corporate assets. With the rise of equity ownership in the United States during the early 20th century, investors began to use financial accounting for a second purpose – the valuation of shares. It's not clear that financial accounting was ever designed to aid investors in the forecasting of future earnings and cash flows. Nevertheless, financial accounting's ability to summarize myriad numbers into a handful of statistics proved alluring to stock investors.

In the first three decades of the 20th century, improved financial reporting contributed to the public's increasing comfort with financial securities. Wider equity holdings brought the ascendance of the income statement as the primary financial reporting tool. The income statement’s emphasis on growth and profitability allowed better assessment of dividend prospects. In the absence of income figures, investors turned to dividend payments as a crude signal of earning power. Unscrupulous managers could pay large early dividends out of contributed capital to give the impression of robust earnings.

Through the 1934 act that created the SEC, Congress granted it the authority to prescribe financial accounting principles and specify the form and content of financial statements. In one word, the SEC is about disclosure. The SEC also sought to narrow the diversity of accounting practices. The SEC gave itself the power to approve financial statements instead of just requiring their disclosure. Perhaps the best-known part of the 1934 Act was prohibiting company officers from buying or selling their employer’s securities while in possession of material non-public information.

In 1970, the SEC adopted the unaudited 10-Q quarterly reporting format. For the balance of the century, quarterly reporting was a North American custom. To protect against selective disclosure to favored investors or analysts, the SEC promulgated Regulation FD in 2000. When a corporate insider discloses material non-public information to people who may trade in the company securities, then the company must promptly disclose the same information to all interested parties.

The American Accounting Association, National Association of Accountants, Controllers Institute, and Institute of Internal Auditors all failed to garner the respect earned by the AICPA. The investing public came to associate outside auditors with the accounting profession. Annually, the Master of Ceremonies at the Academy Awards introduced the Price Waterhouse partner responsible for tabulating votes.

Auditor prominence created a double-edged sword. While CPAs established brand positioning as members of a learned profession, their promotion efforts inadvertently influenced public opinion. Investors came to believe that CPAs' primary obligation was to the investing public, not to the firm actually paying audit fees, and their purpose was to root out management fraud, not opine on whether balances were prepared in accordance with generally accepted accounting principles. This expectations gap would haunt the profession for the balance of the century.

Disgruntled investors who lost money came to believe they had a cause of action against outside auditors for monies lost. Since the issuing company often had no money, the investors' recourse was to turn to the successful CPA firm for restitution. The threat of litigation against auditors escalated through the balance of the century. A prominent academic estimated that by 1993, legal costs for the largest public accounting firms amounted to between 10 and 15% of revenues.

Chapter 6: Standards

[Kris: This chapter is concerned with efforts to make accounting approaches uniform for easier comparison, highlighting the tensions of who accounting rules serve. There is always discretion and debate, and short-term winners and losers, even if the cash flow should be unaffected in the long term.]

By 1970, the AICPA had lost confidence in the APB. The APB had failed to craft an accepted set of guiding principles, define terms such as revenue and asset, reduce diversity of accounting practices, or stand up to criticism from the industry. Gadflies like Baruch College's Abraham Briloff argued that the absence of an accounting framework allowed financial statements to be incomprehensible to those who use them. Critics concluded that the APB lacked the mettle to create and enforce accounting uniformity.

A 1973 report concluded that financial statements provide useful information for decision making. Perhaps the most important information was that which helped investors and creditors predict the amount, timing, and certainty of a corporation's future cash flows. The report acknowledged that no one really knew how investors and creditors use accounting information to make these assessments.

[Kris: This sounds like an argument against strict uniformity while confirming the general value of reporting.]

Immediately after its creation, the FASB embarked on a 20-year, multi-million dollar Conceptual Framework initiative to anchor US financial accounting standards in defensible principles. Yet, the FASB learned early on that it serves at the pleasure of the SEC, a federal administrative agency created by Congress. Politicians serve constituents, not theories.

One such lesson concerned troubled debt restructuring. Economic weakness following the 1973 Arab oil embargo caused many loans to sour. Major borrowers included New York City, whose deputy mayor for finance was Sandy Burton, a former SEC chief accountant. Lending banks often granted concessions to troubled borrowers to increase the likelihood of loan recovery. Debt restructuring made the shortlist of FASB projects by the mid-1970s.

Regulated banks must satisfy capital adequacy requirements to stay in business. In July 1976, as part of its deliberation process, the FASB heard testimony from leading bankers in New York City. They argued that a tough accounting standard would force lenders to take substantial hits to their income statements when they restructure troubled loans. These banks would then become more conservative with loans to non-prime borrowers. Financially burdened cities, real estate developers, and minority businesses would subsequently have less access to credit.

Another example of politics influencing how accounting standards would evolve:

The SEC had charged the FASB with reducing diversity in accounting practices. The FASB required oil and gas companies to use "successful efforts" accounting. Small companies protested, threatened to reduce exploration to avoid earnings volatility, and lobbied Congress and other federal agencies for help. A DOE official believed that smaller companies would reduce oil and gas exploration for fear of reporting unfavorable earnings trends, and the justice department asked the SEC to postpone adoption for fear of reducing industry competition.

The APB and FASB received the same message from the federal government: Reduce diversity of practice without alienating constituents. The fact that the selection of most accounting principles makes no difference over the long run held no sway in politics.

The volume of accounting rules continues to rise with little sign of abatement. A pernicious consequence has been the changing nature of accounting education. A review of any intermediate financial accounting textbook published since 1980 shows the weight attached to teaching specific rules instead of general principles… perhaps a cause of all these rules was an attempt by auditors to get the opportunity to say "our hands are tied" in the face of management challenges to a recommended accounting treatment. Strict standards could mitigate opinion shopping from rival auditing firms. Compliance with bright-line rules could also limit the expansion of auditor professional liability.

Chapter 7: Science

An implication of the EMH and related statistical research was that financial accounting standards do not matter. Investors in aggregate review all sorts of accounting and non-accounting data to divine company prospects. As shown with the LIFO controversy, there is considerable evidence that investors see through accounting form. Well-functioning capital markets may not need strict conformance with clearly articulated financial accounting rules. If investors were indeed slaves to accounting income, a few bright analysts could earn enormous trading profits after making adjustments for cosmetic accounting standards. No one has yet found a way to do this.

In 1983, Arthur Wyatt, a partner at Arthur Anderson, wrote, "A few accountants and practice are aware of the EMH concept and a lot fewer understand it." He had seen clients:

1. Forgo tax savings to report higher earnings under FIFO

2. Enter into hedging transactions to mitigate accounting risk from foreign currency volatility

3. Jump through hoops to structure acquisitions as a pooling of interests

4. Accept expensive financing terms to keep debt off balance sheet

In short, managers acted as if the stock market is not efficient. Accounting professionals either ignored or disputed the validity of EMH and of underlying research. An efficient stock market should prevent errant accounting behavior. One would think that doing dumb things to finesse earnings will depress a firm's stock price and get its executives fired. However, the EMH may not be sufficient to discipline these managers if they hold incorrect beliefs about investor behavior.

"Sorry, I understand cash flow trumps accounting earnings, but those naive investors do not. I'll make accounting choices that give them earnings trajectories they think they want."

Critics of CAP and the APB had charged that these bodies had promulgated financial accounting standards in the absence of guiding principles. Bulletins represented ad hoc fixes while academic attempts to fashion accounting postulates gathered dust.

The FASB sought a foundation to support its statements. The resulting Conceptual Framework became the largest, most expensive effort ever undertaken to document a theory of financial reporting. The seven statements of financial accounting concepts published over 22 years consumed untold millions of dollars and man-hours to produce at the time of this writing. The Conceptual Framework stands as the reigning champion of accounting theory. This work represents the best effort put forth by standard setters to craft a science of accounting. The framework does not codify accounting rules, a task that has proven impossible to date. Instead, the framework offers principles the FASB has increasingly used to frame financial accounting debates.

At the end of the day, a humble accountant must decide whether to recognize a transaction in an accounting period, what dollar amount to assign to that item, and where in the financial statements that item should appear. Economic research has helped predict how accounting practices affect security prices, but this science is yet to tell a bookkeeper what to do.

Chapter 8: Inflation

The issue of inflation accounting is the first instance where academics were able to apply science to resolve a financial accounting debate. This chapter serves as a case study of what could happen if academics and practitioners communicate more effectively.

In 1913, the year modern income taxation became law, the government created the Federal Reserve to serve as a central bank and promote monetary stability.

Bulletin 33 came after the wave of post-World War II inflation and ASR 190 came on the heels of the first oil shock. Statement 89, which killed off inflation accounting, came with decelerating inflation. A literature search showed that tame inflation in the 1990s corresponded with an absence of discussion on this topic in the business press.

• Tactically, the inflation accounting experiment failed. Users did not find restated balances relevant or reliable. In addition, LIFO inventory accounting provided only a partial solution because inventory costs remaining on the balance sheet became increasingly out of date.

• Strategically, the debate shows that academics could help statement preparers resolve a financial accounting dispute.

Chapter 9: Volatility

The second seminal event in the history of corporate finance was the development of the capital asset pricing model. However, financial statement preparers paid little attention to this groundbreaking concept. Consequently, corporate management did not overcome an ill-conceived fear of reporting volatile earnings.

While working at the RAND Corporation, William Sharpe met Economist Harry Markowitz. Markowitz's famous 1952 paper, “Portfolio Selection,” showed that diversification reduces risk. However, Markowitz struggled to pinpoint how the correlation among returns of individual holdings influences aggregate portfolio risk.

The required return, also known as the cost of equity, represents expected earnings needed to attract equity capital for a particular investment. This forward-looking measure depends on investor sentiment and cannot be observed directly.

Sharpe published the Capital Asset Pricing Model in 1964. Sharpe, Markowitz, and Merton Miller shared a Nobel Prize in 1990 for laying the foundation of modern financial economics. Sharpe argued that the investment risk of a given stock is not about raw volatility. Investors face risks that can and cannot be eliminated through diversification. Buyers of financial instruments demand to be compensated for systematic risk resulting from swings in economic activity. They are less concerned with idiosyncratic risk.

A major hurricane could cause substantial damage to homes in Miami. A local property insurer faces ruin. Financial markets will not punish this firm with exorbitant equity costs. Potential investors can diversify by holding shares in a lumber company that would see sales rise in the event of a major windstorm. The presence or absence of a hurricane would little influence combined returns of both securities.

Firms with cyclical sales, high fixed costs, and lots of debt bear more systematic risk and endure higher capital costs. Since gold prices do not move with general economic activity, CAPM suggests a gold miner’s capital costs would be low. A debt-laden, high fixed-cost cyclical telecom firm would have to offer robust returns to attract investors.

It's not clear how earnings volatility affects a firm's cost of equity.

Problems with reporting volatility have caused tension between standard setters and statement preparers since the 1930s. Managers believe investors consider bumpy earnings a blemish when evaluating a firm's earnings power; by contrast, standard setters want companies to tell it like it is, alerting outsiders to the presence of warts on a corporate earnings trajectory.

Three case studies illustrate this tension.

1. Currency translation
The 1944 Bretton Woods agreement controlled currency exchange rates and limited foreign currency accounting significance. On August 15th, 1971, President Nixon imposed price and wage controls and closed the gold window, no longer allowing central banks to exchange dollars for gold. Bretton Woods rules ceased to exist. Within two years, the world economy moved to a system of floating exchange rates.

2. Accounting for the value of defined benefit pensions which depend on interest rates and are long-duration liabilities
For example, a 1939 prescription for calculating pension expense. The prescription reads more like tax return instructions rather than guidance for keeping a set of books. Two constituents benefited from the replacement of a principle with a rule. The SEC received protection from charges of political favoritism, and auditors could reduce malpractice litigation by demonstrating company compliance with quantitative standards. The loser was the role of judgment in the financial accounting profession.
Later rule changes allowed corporations to change interest rate and investment return assumptions to modify pension expense and smooth earnings volatility.

3. The valuation of financial securities held in corporate portfolios
Instead of accepting volatility as a normal consequence of business operations, statement preparers embraced “accumulated other comprehensive income” as US Financial Accounting's Island of Misfit Toys, a place to store unwanted volatility from mark-to-market accounting.

Chapter 10: Intangibles

Financial Accounting evolved from a means to monitor management stewardship of assets into a tool used by equity investors to value shares. Nowhere in the process did the field adapt to the rise of intangible assets. How to account for internally developed intangible assets remains the field's greatest unsolved mystery.

Intangible assets represent those invisible resources such as brand, culture, customer lists, and process knowledge that help companies grow profitably. These amorphous tools often cannot be bought or sold independently of the company itself.

By 2000, intangible resources came to be recognized as the only significant corporate asset class worth acquiring. Most receivables, inventory, machinery, and land can be replaced easily.

In 2002, Microsoft's total recorded intangible assets represented just less than 1% of the company's market value but the accounting problem with intangible assets is not relevance but reliability.

In 1944, CAP distinguished:

1. Purchased intangibles from those developed internally

2. Those with finite lives (patents and licenses) from those with indefinite lives (goodwill and perpetual franchises).

There was no guidance for valuing internally developed intangibles.

For intangibles with indefinite lives, they should be carried at historical cost. Once the finite lives of the assets are in view, then they can be amortized.

By 1970, the APB concluded that all intangibles have finite lives and should be amortized over the estimated period benefited, not to exceed 40 years. 40 years was a practical solution reasoning that every intangible asset value must eventually drop to zero.

In 1974, the FASB put forth the most concise standard in US GAAP:

All research and development costs encompassed by this statement shall be charged to expense when incurred.

Again, the objective is to reduce the diversity of accounting practices. They chose to require immediate expensing because of the uncertainty of future benefits arising from R&D projects and the lack of a demonstrated causal relationship between R&D spending and future revenue.

Pharmaceutical companies have enormous R&D programs. Successful drug companies trade at high price-to-book values because the market implicitly capitalizes previously expensed R&D disbursements when valuing shares. In other words, investors believe GAAP understates these firms' net assets.

In 1985, the FASB decided to expense all R&D but then established an exception for software development.

Spring loading? (the case of IBM buying Lotus 1 2 3) — Taking a large one-time charge that helps a firm show subsequent earnings growth after new management comes to power.

In 2001, standard setters once again did not address accounting for internally developed intangibles. The focus was on intangibles acquired through purchase or merger. Instead of concluding that all intangibles are wasting assets with finite lives, the new standard concluded that goodwill and other intangibles have indefinite lives and should not be amortized arbitrarily. They should be tested for impairment at least annually, and any identified impairment should be charged to income.

To this day, standard setters have not determined how to value internally developed intangible assets other than software.

Case of AOL

AOL spent heavily to grow a subscriber base quickly. Publicly traded firms needing more financing feel enormous pressure to report consistent profits. Bill Sharpe’s arguments about diversifiable risk mean little to aspiring corporate treasures.

AOL capitalized acquisition costs on the balance sheet and amortized them over 24 months. If AOL had expensed them, it would have reported losses. Literally, accountants would shy away from capitalizing intangible asset development costs because it is hard to match these costs with uncertain future revenues.

AOL grew through a series of remarkably bold acquisitions. Its soaring stock price created a currency to buy significant companies. When it eventually bought Time Warner, one critic described it as “one company without assets buying another one without a clue”. Nearly 2/3s of AOL's assets were goodwill.

(AOL would eventually agree to a $3.5 million fine to restate 1995 and 1996 earnings.)

In 2002, Corporate America paid the price for its 1990s acquisitions binge. It recognized $140 billion of intangible write-offs, a sum equal to the write-offs of the prior eight years.

Chapter 11: Debt

Practitioners showed little interest in the efficient markets hypothesis. As a consequence, many statement preparers believed that outside creditors and investors could be fooled by the optics of financial statement presentation. The form of a balance sheet could seemingly trump economic substance when analysts evaluated a company's health. This belief manifested itself most clearly in accounting for debt on the balance sheet. The presence of debt came to be viewed as a sign of corporate weakness. Management teams pushed standard setters to permit companies to keep debt off the balance sheet presentation.

The fraction of a firm's asset base financed through liabilities is perhaps the most significant issue in corporate finance.

Since 1894, the US tax code has permitted interest expense deductions when computing a corporation's taxable income. However, the tax code makes no such provision for dividend distributions to investors. The deductibility of interest makes a firm's capital structure, the share of long-term financing allocated between debt and equity, a determinant of firm value. Some debt gives the firm protection against income taxes, but too much exposes the firm to bankruptcy.

The tension: Debt financing provides a tax shield and allows capital providers to retain a greater share of the firm's earnings. Substituting debt for equity reduces the number of shares outstanding and raises EPS. Some believe that this further enhances firm value because the discipline required to repay borrowings deters ill-conceived investments but the prospect of financial distress causes lenders to worry that owners could act counter to creditors' interests. Shareholders of overly leveraged firms may salvage positions at the expense of bondholders. Tactics include declaring large cash dividends and leaving fewer assets to lenders in the event of a liquidation, issuing even more debt, which makes old debt riskier and less valuable; selling valuable assets which leaves creditors less collateral to back their loans; or swinging for the fences with risky investments.

This chapter concerns itself with the details of leases and unconsolidated balance sheets as examples of pushing debt off the balance sheet.

Chapter 12: Options

The third significant idea in the history of finance was the development of the Black-Scholes option pricing model. This chapter describes how compensation with options replaced debt as a governance tool in the 1990s.

The Black-Scholes model allowed accountants to resolve a long-standing debate, yet practitioners remained slow to embrace this tool. Corporations did not charge option-based compensation expenses to income statements. Financial accounting thus enabled some corporate boards to make outlandish use of this compensation tool.

Academics spent decades trying to solve the problem of option valuation.

• In 1933, two Columbia professors stated that option contracts had not been traded long enough to permit the formation of any intelligent judgment of their value.

• A legal scholar in 1953, concerned with the decline in real purchasing power for executives from 1939 to 1951, thought stock options would be a tax-efficient means of restoring executive pay, but he was concerned there was no realistic method of arriving at a dollar value for an option.

• An accounting theorist in 1970 acknowledged there was no definitive way to value options. Even Paul Samuelson and Robert Merton could not find a general solution.

• Accounting bodies had wrestled with option valuation since the 1940s, especially within the context of compensation.

In the spring of 1973, the CBOE opened for business and the May-June issue of the Journal of Political Economy published the “Pricing of Options and Corporate Liabilities” by economists Fisher Black and Myron Scholes, who resorted to stochastic calculus and physics heat transfer equation to solve the problem.

The use of options in executive compensation gained momentum after a 1993 revision to the IRS code, which disallowed deductions for annual salaries greater than $1 million paid to CEOs of publicly traded firms and its four other most highly compensated executive officers. Beginning in 1994, any compensation over the million-dollar limit had to be performance-based to qualify for a tax deduction. Stock options became the tool of choice to satisfy this condition.

Options appealed to cash-poor technology firms seeking to attract, motivate, and retain high-priced talent. Thousands of employees became millionaires from Silicon Valley's class of 1986 IPOs. From 1985 to 1997, stock option awards increased tenfold. From 1970, CEO pay averaged 39 times an average worker's salary, increasing to 1,000 times by 1999.

In 1993, the FASB concluded that options have measurable extrinsic value, which should be charged to expense over an appropriate vesting period. The following year, 3,000 people met at the San Jose Convention Center to protest the proposal. Stock option accounting became so divisive that it threatened the board's future working relationship with some of its constituents. While the board stated unequivocally that options have a value that can be estimated by option pricing models, it only required that firms disclose proforma earnings as if they had used the option models.

The FASB allowed the disclosure alternative to bring closure to the debate, not because it believed that the solution was the best way to improve financial reporting. Arthur Levitt admitted that urging the FASB to back off from its proposal to expense options was the “biggest mistake I made as SEC chairman.”

As of 2001, 99% of the Fortune 500 used employee stock options. By December 2004, the FASB required companies to value option grants with pricing models and charge this sum to earnings over appropriate service periods.

The case study of options accounting shows management's continued preoccupation with reported earnings and disdain for economic research. Unfavorable financial disclosures came before awards, which a senate could argue depress stock prices and increase the number of options granted for a given dollar value of variable compensation. Good news was disclosed after awards to prevent a run-up in the stock price and reduction in the number of options granted for a fixed dollar award.

When offered academic evidence at an FASB hearing that the stock market shrugs off accounting adjustments, the Home Depot chairman snapped, “You're trying to confuse me with logic here, it's not going to work. I deal with the emotional side of the street. I deal with Wall Street.” No amount of science could convince this manager that financial markets are reasonably efficient.

Research confirmed academic intuition. There was no significant consequence of expensing options on company stock prices. The results were consistent with the University of Chicago studies that markets see through accounting window dressing when valuing securities.

Problems with obtaining agreement on valuation and consequent actions of users of options as a compensation tool illustrate the political nature of financial accounting standard-setting.

Chapter 13: Earnings

Previous chapters showed that statement preparers did not pay much attention to the Efficient Markets Hypothesis, Capital Asset Pricing Model, and Black Scholes option evaluation model. Therefore, some management teams believe that:

1. Investors could be fooled by financial statement presentation.

2. Reporting volatile earnings was a sign of weakness.

3. Option awards had little cost.

Consequently, it is not surprising that management at many companies became obsessed with using accounting tools to meet quarterly targets to boost stock prices and inflate the value of option awards.

Earnings represent the single most important item in a corporate financial report. Over a 1 to 10-year horizon, stock returns appear to be explained overwhelmingly by a firm's cumulative earnings during the period. The explanatory power of other possible metrics like dividends, cash flows, and capital expenditures pales in comparison. Equity investors buy securities for the prospect of future earnings. Earnings likely to recur and grow garner the most respect.

At least three problems complicate EPS calculation:

1. Income in the numerator is a flow, while the number of shares in the denominator is a stock.

2. Income often includes peripheral and non-recurring activities.

3. Corporations issue debt, preferred stock, and options, which can all dilute the number of shares outstanding.

Microsoft, on its way to becoming the world's most valuable company, reported earnings that met or beat Wall Street estimates in 41 out of 42 quarters ending December 1996. It is unlikely to be a coincidence that seven of the top 10 1997 Fortune most admired rankings missed fewer than five quarters in the previous 5 years.

The ultimate measure of corporate success in the 1990s was producing a long, consistent earnings trajectory. Rational managers, trying to impress outside observers, routinely met or beat consensus numbers by a small amount. Earnings coming in well above a threshold would simply cause outsiders to raise the bar further.

Earnings management became the art of recognizing gains and losses in an unsystematic fashion to smooth out the bumps.

Of course, all businesses mature. None can grow faster in perpetuity than the US economy; otherwise, that firm becomes the US economy. Corporations that choose to smooth earnings can get into trouble towards the end of the business life cycle. Management must come up with increasingly heroic assumptions to meet ever higher earnings targets extrapolated from a linear trend.

Extreme pressure to produce earnings growth was a 1990s phenomenon. Managers in the 1920s, working at a time of the previous great stock level, felt no such pressure. Contemporary investors did not demand steady year-to-year earnings increases. Rising managers received less frequent promotions or transfers. Executives came from technical and manufacturing ranks and turned to operations, not accounting, to create wealth. A study of earnings released from 1947 through 1966 suggested that period to period movement in earnings was random, even though earnings-based executive compensation emerged in the 1950s.

The tone changed in the 1990s with the success of blue-chip firms such as General Electric. By 1998, SEC chairman Arthur Levitt bemoaned that accounting had become a “numbers game” where management suppressed common sense business practices, satisfied consensus earnings estimates, and projected a smooth earnings path in an attempt to grow a company's stock and the value of their underlying options.

The EPS bubble burst when accounting scandals came to light at the turn of the millennium. What seems to have been occurring was a game in which analysts and investors were testing the quality of a company's stated earnings by determining whether management could hit its targets. This odd game of inferences created the strange market phenomenon in which companies that missed their earnings by a penny or two saw 20 to 30% declines in their share prices. Reported earnings became important because management actions made them so important!

A parallel story to the EPS drama was the rise of pro forma earnings. Technology firms in the 1990s issued press releases featuring pro forma earnings figures in addition to earnings prepared under GAAP. Telecom companies' enormous infrastructure investments saddled earnings with large depreciation charges. Management chose to focus investor attention on earnings before interest, taxes, depreciation, and amortization. Warren Buffett poked fun at this practice of EBITDA.

However, researchers compared stock prices and earnings data for companies that did and did not report pro forma numbers. They found little difference in stock price behavior. In other words, investors did not appear to price shares of firms issuing pro forma earnings differently from those disclosing only GAAP numbers.

Chapter 14: SOX

In 2002, financial reporting witnessed three of the five largest US bankruptcies, the passage of the most invasive security legislation since the Depression, and the dissolution of what had once been the world's leading CPA firm.

This chapter dives into Enron, Global Crossing, WorldCom, Qwest, Tyco, and Adelphia Communications.

Chapter 15: Epilogue

The four dialects of US accounting:

1. Financial accounting offers outside investors information about the likelihood of debt repayment and future dividends.

2. Tax accounting allows the IRS to compute its share of corporate income.

3. Cost accounting helps management control operations.

4. Statutory accounting lets regulators monitor capital adequacy.

Financial Accounting emerged as a tangled collection of rules shaped by messy business practices, even though reporting practices matter little over the long run. Topics such as investment tax credits, debt restructuring, oil and gas exploration, and stock options show how politics hobbled the standard-setting process.

Discretion invited trouble.

We learned that the act of observation disturbed the subject. The more importance users attach to accounting figures, the less comfort users can take in their reliability.

Research related to EMH suggested investors eventually see through gimmicks when setting security prices. They do not necessarily punish raw earnings volatility, and acceptance of option pricing models may have led to expensing of grants and more intelligent use of this incentive tool.

Today's financial accounting issues will continue into the future. The resources spent to create a conceptual framework will likely show little benefit. Accounting will remain a pragmatic tool full of idiosyncrasies. Well-crafted principles will not solve these problems either, based on studies of pooled interests, leases, and lost contingencies.

And finally, no control system can ever guard completely against bad management behavior. The only workable solution is for corporations to select CEOs with impeccable integrity.