Attention: Technical Director

Dear Sir/Madam:

FEBRUARY 2005 - In 1976, FASB issued three discussion memorandums covering a new conceptual framework for accounting. The memoranda were the direct result of the AICPA’s Objective of Financial Statements, of 1971, based on the work done by a nine-member committee that became known as the Trueblood Committee after its chairman, Robert M. Trueblood, then managing partner of Touche, Ross & Co.

Briefly, the memoranda proposed two radical shifts in financial accounting: The first was that the primary purpose of financial statements should be to provide investors and creditors with information in making rational decisions regarding their investments. (The longstanding stewardship function of accounting was relegated to a secondary position.) The second was that “earnings” should be determined from an asset-liability (balance-sheet) view rather than the longstanding revenue-and-expense view. In short, earnings should be determined from an economist’s rather than an accountant’s view. In 1976, at the annual meeting of the American Accounting Association in Atlanta, FASB Vice Chairman Robert Sprouse, during a debate with SEC Chief Accountant Sandy Burton, stated that there could be no question that ideally earnings for a given period could best be determined by the discounted change in the values of the beginning and ending balance sheet. He added, however, that determining the rate to use was open to question. Burton replied that he could not agree with that approach, and this debate has continued to this day.

It was apparent to many of us that the reason for this radical shift in financial accounting to a balance-sheet view of income was to lay the groundwork for a move from the historical cost model to a fair value one, with the eventual determination of income as Sprouse had espoused in Atlanta. The most notable opposition was led by two partners from Ernst & Ernst, Robert K. Mautz, who had previously taught at the University of Illinois for 25 years, and Albert A. Koch. In 1977 they gave a series of seminars that were sharply critical of the project. The Financial Executives Institute’s [FEI] Committee on Corporate Reporting took up the argument as well.

At that time I was a general director of corporate accounting and reporting on the corporate comptroller’s staff of General Motors Corporation. Thomas A. Murphy was chairman of the board. He was also chairman of the newly formed committee on accounting of the Business Roundtable. When the discussion memoranda on the conceptual framework were published he told me to “get into this in depth,” and I did, eventually publishing a book: Accounting—How to Meet the Challenges of Relevance and Regulation (published by Wiley in 1984; republished with a new foreword in 2004 by Elsevier Science). In that foreword I reiterated my opposition to a fair value accounting system and analyzed what has happened since FASB set out upon the fair value path.

Now, after 28 years of the conceptual framework and a plethora of rules, we have experienced the largest frauds by top management in history: Enron, WorldCom, Qwest, Adelphia, Tyco, HealthSouth, Rite Aid, Global Crossing, Parmalat, and Ahold, to name 10 of the biggest. Six of those—WorldCom, Adelphia, Tyco, HealthSouth, Rite Aid, and Ahold—were of the mundane variety (e.g., falsifying Medicare claims at HealthSouth). The other four (Enron, Qwest, Global Crossing, and Parmalat) involved the use of derivatives (with the cooperation of banks) in creating earnings. The escapades of Enron, and all of the other companies except HealthSouth, Parmalat, and Ahold, are described in Infectious Greed: How Deceit and Risk Corrupted the Financial Markets by Frank Partnoy (Henry Holt & Company, 2003). The frauds at HealthSouth, Parmalat, and Ahold were discovered after the book’s publication.

Of course the primary cause of these huge frauds was not FASB. It was the general decline in the ethical values in the past 30 years, which included the business community as well as public accounting. Dennis Gioia, professor of organizational behavior at Pennsylvania State University’s Smeal College of Business, spoke of this decline at the Academy of Management in August 2002, in relation to the MBA programs: “[T]he call of the share price … as assessed by Wall Street, is very strong.… [I]f the returns are not substantively there, then at least the appearance of returns has become a corollary imperative. [This] has led people to lie, to cheat, to steal, to hide information and to behave in patently unethical ways.” Professor Arthur R. Wyatt, speaking at the annual meeting of the American Accounting Association in August 2003 [CPA Journal, March 2004], spoke of the decline in ethics in the public accounting profession. He pointed out how the action of the Federal Trade Commission in 1979 (forcing public accountants to compete), coupled with the rise of the consulting sector of accounting, led to public accounting firms aggressively seeking the more profitable consulting work over the now less lucrative audit work. As he put it, “Just as greed appears to have been the driving force at many of the companies that have failed … greed became a force to contend with in the accounting firms.”

However, while the decline in ethics was the primary cause of the many frauds we have experienced, there were several enabling factors. One was Congress and its reluctance to provide the SEC with adequate staff as well as allowing the Glass-Steagall Act to lapse, thus giving the investment banks free rein. (“The Investigation” by John Cassady in the New Yorker, April 7, 2003, describes the result: how New York State Attorney General Eliot Spitzer’s investigation of the 10 largest banks in the world led to a $1.4 billion fine for improperly “hyping” stocks during the dot-com boom.) Certainly the corporate boards and audit committees were too lax in many cases.

Insofar as accounting itself is concerned, however, the two principal enablers were the steady move to fair value accounting by FASB and the decline in professionalism cited by Mr. Wyatt. Chapter 10 of Professor Partnoy’s book explains how the highly subjective pricing of long-term natural gas contacts or the pricing of “dark” fiber was an open invitation to unethical, greedy people (of which there are too many) to manipulate earnings. Or consider Mariner Energy, an offshore oil-and-gas exploration company in which Enron held a controlling interest. Under FASB’s rules it had to use fair value accounting. This meant that any increase or decrease in the value of Mariner’s oil reserves had to be reflected in earnings. This was too good an opportunity to miss. BusinessWeek (February 15, 2002) reported that the Enron Risk Assessment & Control Group began offering valuation ranges for management to use. The range for Mariner was $80 million to $350 million. The SEC filed a civil action on October 9, 2003 (Litigation Release No. 18403), charging Wesley H. Colwell, the former chief accounting officer of Enron NA, with fraud. The charge states in part: “Enron, through Colwell and others, fraudulently inflated the value of its largest private merchant asset Mariner Energy, Inc., an oil and gas exploration company. In the fourth quarter of 2000, Enron needed an additional $100 million of earnings to achieve budget targets that formed the basis of its earnings per share objective for the quarter. To meet this need, Colwell and others fraudulently increased the recorded value of Mariner by approximately $100 million. Colwell and others knew that Mariner’s fourth quarter 2000 valuation was an amount arbitrarily selected to generate fictitious mark-to-market earnings sufficient to meet Enron’s targets.”

The problems with such valuations began with the conceptual framework. The Trueblood Committee dealt with not only an economist’s world but a utopian one as well. They never took into account that a certain percentage of people are dishonest, are unethical, and sometimes get into positions to take advantage of the honest people in the world. Furthermore, they chose to ignore the responsibility any standard setter has to aid both the public accountant as well as the company accountant in their work by reducing the subjectivity of accounting as much as possible. The standard setter should be a part of the solution, not a part of the problem. FASB has chosen instead to remain aloof to the problems of subjectivity faced by those practicing accounting. Instead it approaches accounting as a valuation process employing esoteric formulas that would be more in place in a doctorate thesis.

All of us practicing accounting recognize that the basic financial statement is the balance sheet. We recognize that the income statement is really the detail of the retained earnings section of the balance sheet and that the funds statement is a recast of the balance sheet accounts. We also realize, however, that with the growth of the stock markets and public offerings of stock in the 20th century, the emphasis of those using the financial data shifted from an emphasis on the balance sheet to the income statement and earnings per share as a “shorthand” estimate of future cash flows. Unfortunately, the emphasis has also shifted to the short-term investor as well. FASB has fed the short-term investor with its promises of valuations of a company’s future. One FASB board member told me, at a lunch meeting in 1978 at which I was the GM representative, that the life work of FASB should be to lay the basis for an orderly capital market so as to maintain the free enterprise system. That certainly is a noble goal and one that I agree with. The way to do that, however, is to reduce the subjectivity in accounting. This is why the historical-cost model has held up so long under attacks by the economic-oriented theoreticians. Cost gives the auditor a solid base upon which to form an opinion.

The principal problem that financial accounting should deal with is top management fraud. One has only to review history to see that when we faced a crisis in financial accounting it was due to top management fraud (e.g., Kreuger and Insull in the l920s; McKesson & Robbins in 1930s; Equity Funding, Watergate, and Lincoln S&L in more recent years). Again and again we have attempted to control such frauds with legislation—the 1933 and 1934 Securities and Exchange Acts, the Foreign Corrupt Practices Act, and, most recently, the Sarbanes-Oxley Act. But we have failed to realize that we need an accounting base that is at least auditable. Congress formed the Public Company Accounting Oversight Board (PCAOB) but its thrust is toward auditing standards and oversight of the public accountants. The latter is certainly needed; however, auditing standards are not the problem—execution of the standards certainly is. The larger problem is with the accounting standards themselves as they place more and more pressure on the accountants and auditors to judge values without any solid basis for such an evaluation.

Much is made of “management of earnings.” And yet FASB often persists in helping unscrupulous businesspeople in this regard. For example: SFAS 87 requires companies to include in their earnings the earnings of the employee’s pension trust, which of course the company has no right to. This SFAS was adopted in l985, and Richard LaBombarde, a research actuary at Johnson & Higgins, was quoted in the New York Times (April 4, 1986): “If the new accounting rules had been used in 1984, pension costs of those 700 corporations that have defined benefit plans which amounted to $21.3 billion, might have been reduced to between $16 and $17 billion.” During the most recent stock market boom, pension expense was understated by probably one-third. Now, of course, in a flat market, the reverse is true. Thus, the effect of SFAS 87 has been to overstate earnings in good times and understate them in bad times. The new standard on goodwill now gives management as much latitude as they choose as they evaluate the future benefit of the goodwill. Such standards do not make the accountant’s or auditor’s job easier.

And they need help. As a part of the aforementioned huge frauds, we have seen the tragic collapse of one of the greatest public accounting firms in the world. Earlier, I quoted Arthur Wyatt on the decline of the public accounting profession. The auditor has moved from being a tough umpire to being a willing participant in too many cases. The auditors have always had to deal with an inherent conflict of interest because the entity they are auditing is paying the bill and has the power to fire them. It will not help accountants and auditors do their work if the application of fair value measurements forces them to substitute their judgment for the clients’ on a regular basis.

As much as I would like to believe that accounting is the center of the business universe, I hold no such illusions. Accounting is a vital part of keeping our system functioning but it can do this by providing reliable data, free of subjectivity to the extent possible. The key financial drivers that intelligent investors are interested in are market share, market growth, speed to market, competition, and, most important, responsible, ethical management and people. Nothing can quantify the early Sam Walton or Michael Dell; the accountant or auditor can attest to the performance of such managers only through the financial results of their efforts.

Keep in mind that FASB should be part of the solution, not a part of the problem. FASB should take a long, hard look at what it can do to make the accountant’s and auditor’s job easier and the financial reports more reliable. Then FASB will be relevant.

In answer to your question, “Will entities be able to consistently apply the fair value measurement objective using the guidance provided by this proposed Statement together with other valuation standards and generally accepted valuation practices? … If not, what additional guidance is needed?” You cannot get there. Prices are set by independent buyers and sellers, not by guesses and hopes.