Principles-Based Accounting and the Continental Vending Decision

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JULY 2006 - Having been associated for over 40 years with the firm that audited Continental Vending and being well-acquainted with the three defendants, I read with great interest the article “Principles-Based Accounting” by professors Ron Mano, Matt Mouritsen, and Ryan Pace (February 2006 CPA Journal). I would like expand upon and clarify the circumstances of this unfortunate case and its implications.

The article states that the auditors knew that Valley would be unable to repay the receivable carried as an asset by Continental Vending and that there was only a “relatively obscure” footnote explaining the circumstances. In fact, before signing off on the financial statements, the auditors required the debtor to pledge collateral whose value exceeded the carrying amount of the receivable. In addition, the auditors continued to follow the value of the collateral after their audit report was issued and withdrew the report when the value of the collateral declined below the carrying amount of the receivable.

It is surprising for accounting professors to refer to footnotes as “relatively obscure.” Furthermore, in this case, the footnote was anything but obscure, because it formed the basis for the jury’s decision. The jury accepted carrying the receivable as an asset but thought the footnote should have been more expansive. As the authors point out, while the accounting experts thought the footnote disclosures were adequate, the lay jury did not.

The judge’s views on the case are also important. At the sentencing (which I attended), the judge (applying his own instructions to the jury) said he would have acquitted the defendants if he had been the trier of the facts; that is, if there had been no jury. He further stated that he did not know why the government had brought the case and that the matter of the extent of footnote disclosure (if thought important enough) should have been dealt with by the SEC issuing a pronouncement on the subject. The judge’s views on the case were supported by New York State. After a thorough investigation, the defendants retained their CPA certificates because the state concluded they had done nothing wrong.

One last point regarding the authors’ conclusions. While I am not a lawyer, it is my understanding that the decisions of one circuit court are not binding on the others unless the Supreme Court has affirmed the decision (the authors are silent on this point). Thus, it may be that the decision in this case is not binding in all 50 states, although courts may certainly be influenced by the decision if they think it is well-grounded, and auditors should certainly be mindful of it.

To sum up, the authors should be commended for reminding us about the importance of the principle established by the Continental Vending decision. However, to be fair to the individuals involved, it should also be remembered that many people, including the judge and New York State, believe the case itself was wrongly decided.

Ronald J. Murray, CPA (Retired)
Stamford, Conn.

Editor’s Note: The writer is a former member of the FASB Emerging Issues Task Force (EITF) and Advisory Task Force on the Consolidation Project, the International Accounting Standards Committee (IASC), and the AICPA Accounting Standards Executive Committee (AcSEC).

The authors respond:

We thank the letter writer for his amazing and insightful comments regarding our article and the Continental Vending case. They are extremely helpful in clarifying our understanding of some additional issues relating to the case. We certainly will remember these comments whenever we refer to the case in the future.

Ron Mano, Matt Mouritsen, and Ryan Pace
Weber State University
Ogden, Utah.

Mixed Messages About the Accounting Profession

Editor-in-Chief Mary-Jo Kranacher’s April editorial (“Regulating the Accounting Profession”) sends several mixed messages that merit comment.

The editorial first asks why accountants are allowed to practice accounting without passing the CPA exam, observing that there is no parallel in medicine or law. But “accountant” covers a wide range of individuals, from clerical personnel to true professionals, filling a range of societal needs. We don’t have a similar situation in medicine or law; there is no need for generic but unlicensed doctors or lawyers. Accounting is more like engineering, where the term “engineer” may signify a janitor (custodial engineer), construction worker (operating engineer), or a licensed professional engineer.

The editorial further states that the only function that distinguishes a CPA from any other accountant is the ability to sign off on a public audit report. But this is precisely the nature of our licensing. While CPAs claim and indeed possess expertise in many areas of accounting, auditing and attestation is our one licensed function. Some years ago, during the consulting/“XYZ credential” era, some wanted the initials CPA to mean “certified professional adviser.” Maybe that general idea is good, and we should emphasize ourselves as “certified public auditors.”

Interestingly, the profession is attempting to narrow the gap, making it easier to get a CPA by downgrading experience requirements. The need for diverse audit and attestation experience is questioned on the grounds that many (most?) CPAs do not currently engage in such work. But won’t broadening the experience requirement reduce the average qualifications, skills, and experiences of CPAs, leading ultimately to diminished prestige for the profession?

The editorial further compares starting salary ranges for accountants, attorneys, and physicians, suggesting that our field lags behind. When starting salaries are related to post-baccalaureate education—zero to one year for accountants, three years for lawyers, and three years plus an internship and residency for physicians—maybe the differentials are reasonable.

Surprisingly, the next paragraph bemoaned the cost of the extra year of education, asking if it is any “wonder why we’re having difficulty attracting the best and the brightest to our profession?” Yet I see no shortage of lawyers, despite the requirement of three years of post-baccalaureate education. Nor would I suggest that most of those attracted to medicine are not bright.

Our constant harping on not getting the best and brightest is an insult to large numbers of our accounting graduates. As a long-time faculty member, I’ve seen plenty of very bright people enter the profession. But I also see most of them leave public practice within five years. They go from being totally focused on landing a Big Four position to “I can’t wait to leave.” Our problem is not in attracting the best and brightest, but in keeping them. Why is the profession so unattractive as a long-term career option? Interestingly, while the post-Enron era has enhanced enrollments in accounting education, it has also seemed to enhance departures from public practice, especially within the partner ranks. Why do we have so much movement out of the profession? Certainly there is great demand for the skills and experiences gained during public accounting employment—far more demand than exists for the experiences of law or medical practice—but it also strongly suggests that there is something about the profession that is not very attractive.

Ultimately, the question will be whether accounting continues to merit its status as a profession. One hallmark of a profession is the existence of a body of technical knowledge that the members of a profession have and laypeople don’t. Virtually anyone can pursue an accounting degree, so the technical expertise extends far beyond the ranks of licensed professionals. Anyone can go to an office supply store and buy considerable tax expertise in a $29 software package. If licensed CPAs possess something that non-CPAs do not, it is the great diversity of experiences that comes from client service gained through public practice. Once again, we should think carefully before we eliminate this distinction by expanding the experience base for licensure.

Ronald J. Huefner, PhD, CPA
Distinguished Teaching Professor
State University of New York at Buffalo

Not Hopeful About the Profession’s Future

The message of Editor-in-Chief Mary-Jo Kranacher’s May editorial (“Litigation Risk Management: Has the CPA Become the CYA?”) is right on target. Compounding the problem is that the Big Four and other large firms are quite comfortable, and more than adequately compensated, by doing defensive work. “Verify but don’t be creative” is their mantra. The notion of providing value-added services is a low priority—if it is a concern at all.

I would like to think that CPAs can once again become trusted professionals, valued as a business resource, but I am not hopeful. Going down such a path would be too risky. Institutionally, we are evolving into something much less than what we once were. The task of arresting the decline can be nothing short of Herculean. Where is the leadership with the courage to accomplish the task?

Thanks for speaking out. How refreshing!

Joseph V. Bencivenga, CPA
Bencivenga Ward & Co. CPAs, P.C.
Valhalla, N.Y

Fair-Value Accounting: What’s So Fair?

I read with interest the article “Fair-Value Accounting: Analyzing the Changing Environment” (April 2006). One area of the debate should receive close scrutiny: conservatism. Historical-cost accounting is liberal with liabilities and tight with assets. To that end, contingencies, probable liabilities, and other “bad” things are measured, recognized, and always disclosed.

Historical-cost accounting intentionally puts the onus on conservative measurement so that the worst-possible scenario will be reported as the financial position. Fair-value accounting allows managers to present more “good” information to investors, effectively ignoring the concept of conservatism.

For transparency’s sake, investors who are interested in the fair value of a company can use a cost-to-market ratio and create their own fair-value report (basing it on the investor’s own judgments). The management’s financial report and its auditors should not be in a position to decide about the fair-value judgment on behalf of the investors.

Yigal Rechtman, CPA, CFE, CITP, CISM
New York, N.Y.

The author responds:

I understand the concern that a shift toward fair-value accounting might violate the accounting tenet of conservatism. In responding, I would like to discuss three issues related to the reader’s concerns: the relevance of historical-cost versus fair-value accounting; the meaning of conservative reporting in FASB’s viewpoint; and the role of conservatism in fair-value reporting.

Relevance of historical-cost accounting versus fair-value accounting. The current system of historical-cost reporting is not meeting the needs of investors. According to NYU professor Baruch Lev, the relationship between market values and book values of companies on the S&P 500 was approximately 1:1 in the late 1970s and early 1980s. Today that relationship is approximately 6:1. The historical-cost system, created during a time of fixed-asset–based companies that obtained financing primarily from creditors, does not provide a good representation of value in our knowledge-based economy. Reporting our best estimate of the current values of assets and liabilities and disclosing information about ranges of possible outcomes seems to provide more complete information than simply relying on historical-cost financial information that is conservative and reliable but not very relevant!

Most financial statement preparers, standards setters, and users would concur that the primary characteristic of financial information is that it should be useful in the decision-making process. The two primary characteristics that contribute to usefulness are relevance and reliability. Our article discussed these characteristics at length, and, to summarize, it is frequently necessary to trade relevance for reliability. In the ideal world, we would like to increase relevance—the ability of information to affect a decision—and increase reliability—the fair representation of the financial information reported. New accounting standards and proposals place greater emphasis on providing relevant financial information to users, perhaps at the expense of reliability. This shift is evident in FASB’s recent activities that increase the use of fair-value accounting. A recent example of FASB’s focus on fair value is the exposure draft on business combinations.

The definition of conservatism in an accounting environment. Where does conservatism fit into the primary accounting qualities of relevance and reliability? In practice, the idea of conservatism has been altered from FASB’s original intention. Statement of Financial Accounting Concept 2 defines conservatism as “a prudent reaction to uncertainty to try to ensure that uncertainty and risks inherent in business situations are adequately considered.” This suggests that if the reliability of a measurement is not certain, the preparer should carefully consider how uncertainty would affect users’ decisions and, thus, how information about the uncertainty should be portrayed. This definition does not imply that financial statements should always be pessimistic. The role of conservatism is for preparers to acknowledge that risks and uncertainties are present in financial information and to adequately account for those risks in the information that is presented to decision makers.

Conservatism in a fair-value environment. Based on the above discussion, how does conservatism impact the current movement toward measuring assets and liabilities at fair value? In an environment clearly moving toward fair-value measurements, the importance of conservatism, as originally intended by FASB, may be even more important than in an historical-cost environment. Specifically, conservatism was meant to encourage accountants to consider the uncertainties surrounding their measurements and the impact those uncertainties and risks might have on decision makers. This is critical in today’s marketplace.

In a fair-value environment, financial statement amounts are determined by using estimates of discount rates, cash-flow streams, income streams, and others to establish the fair value of a particular asset or liability. When choosing between alternative assumptions, accountants should be conservative and consider the inherent uncertainties and risks of the asset or liability they are measuring. Furthermore, after establishing the best estimate of current value, the uncertainty and risks inherent in the fair-value estimates should be reported through detailed disclosures about the assumptions used and the range of possible outcomes if alternate assumptions were used. This is the approach followed in the fair-value-measurements exposure draft. The objective of the exposure draft is to improve the consistency and comparability of fair-value measurements and to require increased disclosures so that investors can adjust the reported values as they see appropriate. This process provides relevant financial statements with detailed information that would allow users to assess risks and thus allow them to create more-conservative estimates of corporate value.

To summarize, the current system of financial reporting frequently seems to focus on providing reliable information that is conservative, if not pessimistic, in nature. This focus on reliable information has resulted in an accounting system that produces financial information that is frequently not relevant to investors and other users of financial information. FASB’s current focus on fair-value accounting would provide users with much more relevant information that may not be as reliable. One critical component of this new system is that preparers will have to be vigilant in disclosing information about the assumptions made to determine values, and report the uncertainties involved in those assumptions. Thus, accounting is shifting the focus of conservatism from reporting the worst-case scenario to providing detailed information about assumptions and uncertainties surrounding those assumptions, so that users can make informed decisions about corporate measures of fair value.

Rebecca Toppe Shortridge, PhD, CPA
Northern Illinois University, DeKalb, Ill.




















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