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Whom Do We Account?
JUNE
2005 - In Senate Banking Committee hearings in 1932, a revelation
galvanized public opinion in support of federal regulation
of securities offerings, securities exchanges, and banks:
Between 1924 and 1929, executives of the National City Company
(NCC) had manipulated stock prices in order to exercise
favorably priced stock options, and then attempted to avoid
paying taxes on their gains from the sale of the acquired
shares. The NCC had been formed in 1911 as a separate investment
banking firm by senior executives of National City Bank,
and it was the first large-scale securities underwriter
that also retailed securities nationwide through an extensive
network of local offices.
The
NCC bankers would take shares, warrants, and options at
favorable prices for themselves and officers and directors
of the securities’ issuers; create the illusion of
volume demand by trading in the securities through a “pool”
until outsiders began to “ride the bull”; issue
favorable analyses on financial statements that included
write-ups to net assets reflecting the price run-up; when
the price was high enough, exercise their warrants and options;
sell their stockholdings, often for astonishing gains; and
subsequently cease trading in the security, causing its
price to plummet. Not satisfied with the gains alone, they
also sought ways to avoid paying income taxes on them.
Split-Screen
Fast Forward
Stock
options became a source of great wealth for investment bankers
and corporate directors and officers again during the 1990s.
Although no one has suggested that insiders created “pools”
to simulate interest in a specific security during that
period, many companies purchased their own securities in
order to maintain high stock prices. On the other hand,
news headlines about hyped analysts’ reports and restated
financial statements have become common.
Many
accounting restatements involve revenue-recognition and
expense-timing issues that arise as by-products of the general
deregulation taking place in our economy and, more specifically,
in our financial institutions. The legacy of the New Deal
was a much more tightly regulated economy than before 1932,
especially in the restrictions regarding the types of assets
that a company could hold, the types of financial instruments
that could be created, and the entities that could engage
in trading financial instruments. Accounting for revenue
and expense transactions became the focus of financial reporting
in an environment where mergers and acquisitions were scarce,
most companies either produced or distributed tangible goods,
and financial instruments were rendered strictly “plain
vanilla” by regulation.
Because
change never takes place in all things ratably, we now enjoy
the fruits of deregulation in financial instruments, although
we have been unable to keep pace in accounting for them.
Creative people daily make up new transactions that accountants
have never seen before and that also defy the application
of GAAP. A company has considerable discretion in how to
characterize many transactions in order to achieve a desired
accounting effect. Indeed, the 1990s gave rise to news headlines
about the great real economic sacrifices some companies
would incur in order to achieve some accounting result,
often motivated by earnings expectations or tax savings.
Accounting
for the Entity
A massive
change in accounting thought took place during the 1930s
in the wake of the securities acts. Although the origins
of accounting for the transactions of an entity, rather
than for the value of the proprietary interests of the entity’s
owners, can be traced to the late nineteenth century, the
concept that you could account for an entity without taking
a perspective became “generally accepted” only
after Paton and Littleton published their corporate accounting
monograph in 1940. That monograph also advanced the concept
of accounting for transactions based on revenue recognition
and expense matching measured at transaction cost.
One
reason that Paton and Littleton developed their approach
was in response to the perceived accounting abuses of the
1920s. The general model for accounting then was focused
on the valuation of owners’ interests in the entity,
which subsumed adjustments of net assets to reflect the
market values of those interests. Paton and Littleton reasoned
that focusing accounting on the economic flows of the entity,
such as revenue and expense, would be more consistent with
a perspectiveless approach than valuing economic stocks,
such as assets and liabilities. Unlike present-day accounting,
however, Paton and Littleton treated the balance sheet as
a residual holding ground rather than as an indicator of
the value of the entity.
The
User Orientation
Because
related developments do not necessarily occur at the same
time, FASB’s conceptual framework, which in 1978 reoriented
financial reporting from the income statement to the balance
sheet, nonetheless retained many attributes of perspectiveless
accounting from the entity approach. Among them are assertions
about general-purpose financial statements, which essentially
embrace abstraction from any known user, and decision usefulness,
which becomes an attribute of information rather than of
users, in defiance of modern theories of information.
If
a balance-sheet valuation orientation is again going to
determine recognition and measurement, then serious consideration
of whose perspective will guide standard development and
accounting practice must also return.
Robert
H. Colson, PhD, CPA
Editor-in-Chief
rhcolson@nysscpa.org
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