Accounting Standards Setting: Inconsistencies in Existing GAAP

By Timothy B. Forsyth, Philip R. Witmer, and Michael T. Dugan

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Much of FASB’s recent guidance has become rule-driven and complex. The areas of derivatives and securitizations are examples. This emphasis on detailed rules instead of broad principles has contributed to delays in issuing timely guidance. Additionally, because the standards are developed based on rules, and not broad principles, they are insufficiently flexible to accommodate future developments in the marketplace. This has resulted in accounting for unanticipated transactions that is less transparent and less consistent with the basic underlying principles that should apply [March 21, 2002].

FASB’s proposal indicates that it accepts this criticism as at least partially valid. Indeed, FASB explains that the level of detail in recent standards is partly attributable to political compromises made in order to gain acceptance of a standard. The compromises include providing for scope exceptions (exempting from the standard some otherwise covered transactions), exceptions that limit volatility of reported earnings, and exceptions to mitigate transition effects to a new standard. Katherine Schipper (“Principles-Based Accounting Standards,” Accounting Horizons, March 2003) argues that FASB generally follows a principles-based approach, but the exceptions and interpretive and implementation guidance provided by FASB may make recent standards appear to be rules-based.

In 2003, the SEC published a staff report in which the concept of principles-based standards was clarified. According to the report, principles-based standards “should have the following characteristics:

• “Be based on an improved and consistently applied conceptual framework;
• “Clearly state the accounting objective of the standard;
• “Provide sufficient detail and structure so that the standard can be operationalized and applied on a consistent basis;
• “Minimize exceptions from the standard;
• “Avoid use of percentage tests (‘bright-lines’) that allow financial engineers to achieve technical compliance with the standard while evading the intent of the standard.”

Even if FASB’s approach is generally principles-based, as defined by the SEC, a large portion of current GAAP is based on standards adopted before the completion of the conceptual framework project or promulgated by FASB’s predecessors, the Committee on Accounting Procedure (CAP) and the Accounting Principles Board (APB). Both the CAP and the APB were heavily criticized for their “piecemeal” approach to setting standards, which resulted in standards that were not consistent with each other or with an underlying set of accounting principles (Stephen A. Zeff, “Some Junctures in the Evolution of the Process of Establishing Accounting Principles in the U.S.A.: 1917–1972,” Accounting Review, July 1994). Some inconsistencies in GAAP are related to basic recognition criteria for assets and liabilities (e.g., noncancelable purchase agreements versus capital leases). Other inconsistencies exist because of differences in measurement criteria (e.g., discounted cash flows in the case of non-interest-bearing notes versus undiscounted cash flows in the case of deferred taxes).

Some areas of existing GAAP seem inconsistent with the first characteristic of principles-based standards, that they be based on an “improved and consistently applied conceptual framework.”

Specifically, these inconsistencies are apparent in three areas: 1) executory contracts, 2) valuation of future cash flows, and 3) stock dividends and stock splits. These accounting issues represent transactions in which a large number of companies engage, and are relatively easy to understand. They do not represent an exhaustive list of accounting rules where inconsistencies exist. A discussion of these inconsistencies hopefully will motivate FASB to resolve them in due course and to strengthen the Conceptual Framework as a theoretical basis for future GAAP.

Purchase Commitments Versus Supply Commitments

Companies enter into purchase commitments to ensure a long-term supply of raw materials and protect themselves from future price increases. Companies enter into supply commitments to ensure future sales of their products and protect themselves from future price decreases. The purchaser is trying to protect itself against rising prices. The supplier, on the other hand, is trying to protect itself against falling prices.

The two primary reporting requirements for parties that enter into purchase commitments are as follows:

• Companies that enter into firm purchase agreements are required under SFAS 47 to disclose in the notes to the financial statements the nature of such agreements and the timing and amount of cash payments to be made, if the purchase commitment (a) is noncancelable; (b) was negotiated as part of arranging financing for the facilities that will provide the contracted goods or services or for costs related to those goods or services; and (c) has a remaining term in excess of one year.
• Companies that have firm purchase commitments have long been required under ARB 43 to recognize a loss in the period in which the market price of goods to be purchased under the agreement falls below the commitment price.

The first requirement is consistent with the objectives of financial reporting described in Statement of Financial Accounting Concepts (SFAC) 1 which states that financial reporting should provide information about the economic resources of an enterprise and the claims to those resources, and information to help investors and creditors assess the amounts, timing, and uncertainty of future cash flows. Unfortunately, the disclosure requirements apply only to purchase commitments associated with project financing arrangements. Because the majority of long-term purchase commitments are not likely to be associated with financing arrangements, investors and creditors may be unaware of such commitments until a loss is recognized under ARB 43.

For example, in its 2001 financial statements, Ford Motor Company recognized a loss of $953 million on purchase commitments for palladium, a metal used in its catalytic converters. During 2001, the market price of palladium had dropped from about $1,100 per ounce in January to about $440 per ounce by year-end, as reported by Gregory White in the Wall Street Journal. In addition to the drop in prices, technological advances in the design of catalytic converters had reduced the need for palladium. Ford not only found itself obligated to purchase palladium at prices higher than market prices, it was also obligated to purchase the metal in quantities it no longer needed.

Ford makes no mention of its palladium contracts in its 2000 annual report, either in the MD&A disclosures about commodity price risk or in the notes to the financial statements. Ford’s only disclosure related to its palladium contracts is a general statement about its commodity hedging program in Note 1, “Accounting Policies,” which states, “Ford has a commodity hedging program that uses primarily forward contracts and options to manage the effects of changes in commodity prices on the Automotive sector’s results. Gains and losses are recognized in cost of sales during the settlement period of the related transactions.”

A class action lawsuit was brought against Ford in January 2002 alleging, among other things, that Ford’s representations of its financial position were false and misleading, because management had failed to disclose its loss exposure related to the unhedged purchase commitments. The lawsuit was subsequently dismissed by the Southern District Court of New York because the plaintiffs did not prove that Ford had made any fraudulent statements about its forward commodity contracts, and the forward contracts did not represent undisclosed speculation. Stronger disclosure requirements under SFAS 47 might have resulted in more transparent reporting of the contracts before the loss occurred, thus eliminating the conditions that gave rise to the lawsuit.

While there is room for improvement in standards related to purchase commitments, there are no existing accounting pronouncements that cover firm supply agreements. By their nature, firm supply commitments entail the same kind of risk as firm purchase commitments. In either case, the cash flow impact of a change in prices can be substantial, but at least financial statement users would have been made aware of any potential losses related to purchase commitments. This is not the casefor supply commitments.

Dugan and Hughes (“Why Not Disclose for Supply Commitments?,” Management Accounting, July 1991) described two cases where firm supply agreements resulted in losses for suppliers. During the 1960s, Westinghouse had entered into firm agreements to supply more than 80 million pounds of uranium to customers at an average price of $10 per pound. The market price at the time Westinghouse entered into these agreements was below $10 per pound, and remained below that amount throughout the early 1970s. In 1974, after the creation of a worldwide cartel of uranium producers, the market price skyrocketed to $45 per pound, and Westinghouse faced potential losses of roughly $2.275 billion. If Westinghouse had experienced the same loss exposure from a purchase commitment, it would have been required to recognize the entire amount of $2.275 billion in losses.

As it was, consistent with existing accounting principles, Westinghouse neither recognized any portion of the potential losses in its 1974 financial statements nor disclosed the existence of the agreements. The notes to Westinghouse’s 1975 annual report provided some disclosure about the potential loss, but concluded that the potential loss was not reasonably estimable. It should be noted that SFAS 5 was not effective until fiscal year 1976, but given the 1975 disclosure note, it is unlikely that any loss would have been recognized in 1975 even if SFAS 5 had been in effect. As a result, the users of Westinghouse’s financial statements were unaware of the agreements prior to the 1975 financial statements, and even then were kept in the dark about the magnitude of the potential losses.

In another case, Texaco, Inc., in its 1980 financial statements recognized losses of $6 million related to supply commitments and disclosed that potential losses on those commitments could reach $815 million. Although the supply commitments had been in effect for 20 years, their existence had never been disclosed prior to 1980. In both cases, financial statement users were unaware of the agreements until losses were imminent. A simple disclosure requirement, such as that required of companies with purchase commitments, would have alerted financial statement users to the potential problems years earlier.

Purchase Commitments Versus Capital Leases

GAAP for leases comes primarily from SFAS 13, which states that if any one of certain criteria is met a lease contract may be viewed, in substance, as an installment purchase of the leased property by the lessee. Such capital leases must be accounted for in the same manner as purchases of assets. Accordingly, the lessee in a capital lease recognizes an asset and a liability equal to the present value of the payments to be made under the lease. A lease that meets any of the following criteria is considered a capital lease:

• The lease transfers ownership of the property to the lessee by the end of the lease term.
• The lease contains a bargain purchase option.
• The lease term is equal to 75% or more of the estimated economic life of the property at the beginning of the lease term.
• The present value of the minimum lease payments at the inception of the lease is 90% or more of the fair value of the leased asset.

The reasoning behind the rule is that although lease contracts are executory in nature, a lease contract that meets one of the above criteria transfers substantially all the benefits and risks incident to the ownership of property. One of the primary reporting problems FASB was attempting to resolve with SFAS 13 was off–balance-sheet financing, where the lessee is obligated to the lessor in a manner equivalent to a purchaser that has obtained debt-financing.

But what about noncancelable purchase commitments where the purchaser agrees to purchase a product over an extended period of time? Both purchase commitments and capital leases are executory contracts that substantively obligate the purchaser (or lessee) to make future payments to another party as long as the other party performs according to the contract terms. Why should obligations under capital leases be recognized, while information about purchase commitments is merely disclosed only when certain criteria are met? One possible explanation is that purchase commitments are fully executory—that is, neither the purchaser nor the supplier has yet performed the contract—whereas a lease contract is only unilaterally unperformed. Under this view, the lessor is considered to have performed its obligations under the lease contract when possession of the leased asset is transferred to the lessee, thus obligating the lessee to make all future contractual payments. It should be noted that legal remedies available to lessors in the event of lessee default are consistent with this view.

SFAC 6 defines liabilities as probable future sacrifices of economic benefits arising from present obligations of an entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. FASB also states that liabilities have three essential characteristics:

• They embody a present duty that entails settlement by probable transfer of assets at a specified or determinable date, on the occurrence of a specified event, or on demand.
• The duty is nearly unavoidable.
• The transaction or other event obligating the entity has already happened.

Clearly, both firm purchase commitments and capital lease contracts display the first two characteristics of a liability: They both embody a present duty to transfer assets, and the duty is virtually unavoidable. The distinction between the two types of contracts would seem to be related to the third characteristic. FASB apparently does not view the signing of a firm purchase commitment as an event that would trigger recognition of an asset or a liability. Such recognition is deferred until the item is delivered. By contrast, leased assets and their related obligations are fully recognized at the inception of the lease, presumably because the risks and benefits of ownership have been transferred to the lessee.

While obligations under purchase commitments do not meet the third characteristic of a liability, it is not certain that all capital leases do, either. For example, in many situations, the lessor is obligated to keep the leased asset in good working order throughout the lease term. Such an obligation implies a continuing economic involvement in the property by the lessor. While the benefits of ownership may have been transferred to the lessee, the risks of ownership have not been fully transferred.

This line of reasoning is not meant to suggest that leases should not be capitalized as required under SFAS 13. Rather, it is to make the point that noncancelable purchase commitments are similar to leases in that both meet the first two characteristics of a liability and neither always meets the third characteristic. To be consistent, FASB should require disclosures as described in SFAS 47 regarding all noncancelable purchase obligations, not only those that meet the specified criteria. As stated earlier, such disclosures would be consistent with the objectives described in SFAC 1, and would have been useful to the readers of financial statements.

Valuation of Future Cash Outflows

An overriding objective of initial valuation and fresh-start valuation of assets and liabilities is to use an observable, marketplace-determined amount. Nevertheless, accountants often find themselves without such an objective measure and must base valuation on future cash flows, such as in the application of impairment accounting. For example, the determination of the impairment loss of a plant asset requires the estimation of future net cash flows to be generated by the asset and then the discounting of those cash flows in cases where there is no objective measure of the current fair value of that asset. Although APB Opinion 21 addressed only the valuation of notes receivable and notes payable, it was the first standard that firmly addressed the valuation of future cash flows at a discounted present value, and in the years since its issuance, it has acted as a broad principle. Recently, FASB has confirmed and expanded this principle with SFAC 7, which states, “The objective of using present value in an accounting measurement is to capture, to the extent possible, the economic difference between sets of future cash flows.” Nonetheless, there are several areas in current GAAP where this objective is not met, specifically, deferred income taxes, troubled debt restructuring, and recognition of interest income under SFAS 115.

Deferred Income Taxes

Given the vagaries of the Internal Revenue Code, the timing of income tax payments often differs substantially from the provision for income taxes under GAAP, occasionally accelerating but most often significantly delaying the payment of taxes. The matching principle requires that this expense be recorded upon the recognition of the associated income. The resulting liability is simply valued at the amount of future taxes to be paid (i.e., not discounted).

An argument for violating the matching principle established under APB Opinion 21 and SFAC 7 is that the timing of the future tax payments, related to the reversal of temporary differences between book and tax income, is too uncertain to be known or estimated. However, SFAS 96, which was never implemented by most companies, would have required a scheduling of those future tax payments. SFAS 109 calls for an estimation of the reversal of these temporary differences in cases where future tax rates have been changed by legislation. This suggests that companies should be able to develop such a schedule, which can be discounted to present value. The objective of using present values is to capture the economic difference between two sets of cash flows; paying taxes today is simply not the same as paying those same taxes next year or beyond. To be consistent with SFAC 7, income tax expenses should reflect the economic differences that result in the timing of those cash payments.

Troubled Debt Restructuring

In cases where a debtor must modify the terms of its debt arrangements because of the risk of default, SFAS 15 has adopted some rules at variance with the principles appearing in APB Opinion 21 and SFAC 7. Upon the modification of the terms of a debt, there exists a new set of cash flows to which the debtor is committed, an example of fresh-start valuation. Strict adoption of the principle would discount that new cash flow stream; determining a discount rate, however, is another issue. Application of SFAC 7 would point to a rate that reflects the current default risk—which, given the circumstances that led to the restructuring, could be rather high. SFAS 114 requires that the creditor discount these same cash flows at the historical rate used to value the original note. The historical rate is certainly more objective than a current default risk rate would be, but the result may be a valuation of the creditor’s receivable greater (and possibly overvalued) than one provided by a market-based valuation.

SFAS 15 does not require the new cash flows to be discounted at the current default rate risk or even the historical rate. Instead, the standard requires that, if the undiscounted cash flows under the new modified terms are greater than the carrying value of the debt (implying positive interest), the interest recognized in the current and future periods be limited to that excess. This rate often constitutes a very low effective interest rate, lower than the historical rate, and much lower than a rate reflective of the default risk. If the undiscounted cash flows under the restructuring are less than the carrying value of the note, the note is written down, and a gain is recognized. No interest expense is recognized in this case, and every dollar paid in the future will be a direct reduction in the carrying value of the note. This treatment has the effect of smoothing the earnings of the reporting company.

An argument for the SFAS 15 approach is that using either a reasonable rate, or even the historical rate, to discount the future cash flows would recognize a sizable gain by the debtor (thus increasing net income in the year of the restructuring), followed by periods of higher interest expense. If the historical rate were used, it would be consistent with the principles of APB Opinion 21 and SFAC 7, as well as the creditor accounting treatment for this same restructuring under SFAS 114. Furthermore, as long as the source and nature of the resulting gain were clearly identified, the resulting accounting would have greater representational faithfulness and better reflect the value of the accommodation provided by the creditor.

The evolution of the accounting for debtor and creditor is interesting. SFAS 15 resulted in symmetrical accounting for debtors and creditors with respect to the modification of terms in a troubled debt restructuring. The position taken by FASB may have been an accommodation to financial institutions that were facing sizable losses from their exposure to Third World countries as well as the U.S. real estate and energy sectors during the late 1970s. In 1993, after this political pressure had subsided, FASB issued SFAS 114, which modified the accounting for creditors by requiring the discounting of the newly agreed upon cash flows at the historical rate, thus removing the symmetrical treatment. FASB stated that the reason for not addressing debtor accounting at that time was that it would have delayed the issuance of the standard.

Recognition of Interest Income

SFAS 115 changed the method of accounting for investments in debt and equity instruments, bringing balance sheet valuation in line with the present-value principle of APB Opinion 21 and SFAC 7. As noted by Kathryn M. Means (“Effective Interest … on What Basis?,” Accounting Horizons, June 1994), however, that principle was not carried to the income statement for the recognition of interest revenue on debt instruments. At each balance sheet date, available-for-sale and trading securities are reported at their current market values; to the extent that the future cash flow has not changed, any change in the market value must have resulted from a change in the implied discount rate. This adoption of market value accounting on the balance sheet therefore incorporates the updated discount rate. Income statement accounting is not consistent with the mandated balance sheet accounting, because SFAS 115 requires that the interest income continue to be recognized at the interest rate implied by the market value of the security on the date of purchase. Any market value adjustment account required to bring the existing carrying value of the debt security plays no role in determining interest income for the following accounting period. This inconsistency is another indication that specific rules override the consistent application of principles.

Stock Dividends and Stock Splits

The accounting literature describes three types of stock distributions to common shareholders that do not involve consideration: small stock dividends, large stock dividends, and stock splits. While the market views these three events as substantively equivalent, ARB 43 requires a different accounting treatment for each type of stock distribution. FASB’s Conceptual Framework provides little guidance in this area. SFAC 6 states that companies have traditionally classified equity as capital stock, other contributed capital, and retained earnings. It further states that because of certain transactions, including stock dividends, such classifications “may or may not accurately reflect the sources of equity of an enterprise. However, those problems are problems of measurement and display, not problems of definition.” SFAC 5, which provides guidance with respect to recognition and measurement in financial statements, is silent on the subject of stock dividends and stock splits.

Stock splits. ARB 43 defines a stock split as “an issuance by a corporation of its own common shares to its common shareholders without consideration and under conditions indicating that such action is prompted mainly by a desire to increase the number of outstanding shares for the purpose of effecting a reduction in their unit market price, and, thereby, of obtaining wider distribution and improved marketability of the shares.” Implicit in this definition is the assumption that in the case of stock splits, the share market price adjusts proportionately to the number of shares issued, and, therefore, recipients of the additional shares do not receive dividend income. It follows that because true stock splits neither provide dividend income to shareholders nor have any impact on legal capital requirements, no accounting treatment is necessary.

Large stock dividends. ARB 43 described stock dividends where the number of shares issued was so great that their market value would be materially reduced as, in substance, stock splits “effected in the form of a dividend.” As with stock splits, because the share market price adjusts proportionately to the number of shares issued, such large stock dividends would not provide dividend income to the recipients of the additional shares. Unlike pure stock splits, however, legal capital changes in the amount of the par value of the newly issued shares. Accordingly, the prescribed accounting treatment is to transfer an amount equal to the par value of shares issued from retained earnings to contributed capital.

Small stock dividends. According to ARB 43, small stock dividends provide dividend income to stockholders because the issuance of a relatively small number of shares does not have any “apparent effect upon the share market price, and, consequently, the market value of the shares previously held remains substantially unchanged.” Based on that assertion, ARB 43 requires companies to account for small stock dividends by transferring from retained earnings to paid-in capital an amount equal to the fair value of the shares issued. Small stock dividends are defined as those involving the issuance of less than 20% to 25% of the number of shares previously outstanding.

Stock Splits and Large Stock Dividends

There are two reasons why no accounting treatment is prescribed for stock splits. First, because par (or stated) values are changed to reflect the additional shares outstanding, stock splits do not change legal capital requirements. Second, the Committee on Accounting Procedure (CAP) assumed that the share price would fully adjust to reflect the additional shares. In this case, the accounting treatment seems to be consistent with the reasons given.

The arguments presented in paragraph 11 of ARB 43 make it clear that the CAP viewed stock dividends greater than 20% to 25% of outstanding shares as stock splits rather than dividends. Unlike stock splits, however, large stock dividends cause a change in legal capital, for which there must be an accounting. Thus, the standard requires a transfer of an amount equal to the par value of shares issued, from retained earnings to common stock, to account for a large stock dividend. While this approach seems reasonable with respect to measurement, a question arises with respect to the charge to retained earnings. If a large dividend is, in substance, a stock split, it stands to reason that retained earnings should not be affected by the transaction. Instead, the change in legal capital would require only a transfer of an amount equal to the par value of the additional shares from additional paid-in capital to common stock.

Small stock dividends and stock splits. Because the CAP correctly asserted that large stock dividends are, in substance, stock splits, the term “stock split” as used below will refer to both types of transactions. As stated above, ARB 43 requires companies to account for small stock dividends by transferring from retained earnings to paid-in capital an amount equal to the fair value of the shares issued. This accounting treatment is consistent with the CAP’s assumption that stock dividends of less than 20% to 25% of outstanding shares do not cause a proportionate change in stock price and, therefore, provide income to recipients roughly equal to the market price per share received. Subsequent market research, however, fails to support the CAP’s assumption about market reaction to small stock dividends. Indeed, several research studies subsequent to the issuance of ARB 43 provide evidence that the market does not view either small stock dividends or large stock dividends as dividends, but rather as splits, with stock prices fully adjusting to the additional shares issued. Thus, while the requirement to transfer an amount equal to the pre-dividend market value of shares distributed to capital stock is consistent with the CAP’s basic assumptions, such an accounting treatment is inconsistent with the current understanding of capital market behavior. Following the CAP’s logic with respect to stock splits, because small stock dividends do not provide dividend income to their recipients, small stock dividends are in substance stock splits and should be accounted for in the same manner as other stock splits.

In summary, given that the market reaction to small stock dividends, large stock dividends, and stock splits is similar, and that none of the three types of stock distributions provides wealth to existing stockholders in proportion to the number of shares issued, all three should be accounted for as stock splits and never as dividends. Accordingly, stock “dividends,” both large and small, would be accounted for by a transfer from additional paid-in capital to common stock, rather than from retained earnings, equal to the par (or stated) value of shares issued. In the case of true no-par stock, no accounting recognition would be required.

Transparency and Consistency

There are several areas within GAAP discussed above where inconsistencies in standards exist. These inconsistencies call into question the transparency of accounting information that is based on those standards. Such inconsistencies should be resolved, and FASB’s Conceptual Framework should be strengthened to minimize the possibility of issuing additional standards that are inconsistent with each other, as well as to provide an even more unified theoretical basis for the development of future GAAP.