The $20 Billion Man

The $20 Billion Man
Former SEC Official Makes Case for Costly Approach to Accounting

Noncash assets included in financial statements are currently un-auditable and give a subjective impression of a corporation’s well-being, an accounting reformer proclaimed last month.

Former Securities and Exchange Commission Chief Accountant Walter Schuetze told a gathering of hundreds of CPAs that items such as deferred taxes and goodwill have no intrinsic value outside “accounting estimates,” which he said are not objectively verifiable like accounts receivable, marketable securities or cash flow are.

“In other words, accounting estimates are management’s ideas about unknowable future events,” Schuetze said in a speech at the Sept. 9 Foundation for Accounting Education’s SEC Practice Under the Sarbanes-Oxley Act Conference. “Those ideas can be nothing but subjective.”

To Schuetze, who served as SEC chief accountant from 1992 to 1995, long after his tenure as a charter member of the Financial Accounting Oversight Board, the subjectivity of financial statements is a problem inherent to today’s accounting system. Today, it is considered appropriate for management and auditors to use their judgment in making estimates on variable items in financial statements, a practice that Schuetze says brought on everything from the Savings and Loans crisis of the 1980s to the Sarbanes-Oxley Act of 2002.

Schuetze has become a vocal reform advocate, imploring Congress earlier this year to swiftly enact the changes called for in Sarbanes-Oxley—along with other former SEC accounting chiefs—and now turning his attention to a systemic change in the way auditors look at financial statements.

The answer to the subjective judgment troubles that Schuetze sees rife in today’s financial statements is in mark-to-market accounting, a system in which noncash assets are independently confirmed, roughly, by valuation experts. Schuetze contends the system would make financial statements more transparent and comprehensible to everyday investors, and would make restatements obsolete, improvements he believes would go far in restoring investor confidence and avoiding another WorldCom-scale collapse.

“The balance sheets of most public companies show some amount of cash which the auditor can verify the correctness of by reference to a bank statement and a confirmation from the bank,” Schuetze said.

The same can be said of other items: accounts or loans receivable can be verified objectively by the debtor; the market prices of securities can be verified by financial publications or a broker; accounts or loans payable, by the creditor.

Other items are not. Schuetze cited the American Institute of CPAs Auditing Standards Board Statement on Auditing Standards No. 57 covering auditing accounting estimates, which includes a litany of items where estimates are allowed. These include credit losses; useful lives and residual values of plant and equipment and recoverability of plant and equipment cost; realization of deferred tax assets; impairment of goodwill, and loss reserves of casualty insurers, to name a few.

Determining the value of these items, Schuetze said, “requires marking to market corporations’ assets and liabilities—estimated, immediate selling price of noncash assets and estimated, immediate settlement price of liabilities not yet due—which in turn requires separating the reporting responsibilities on corporations’ balance sheets between external auditors and external valuation experts.”

The prices would still be subjective to a degree but would not be “masquerading” amounts as certain, “as accounting estimates do in today’s financial statements,” Schuetze said. In other words, they would be more objective.

The new system would have management develop estimates on the value of noncash assets and liabilities not yet due, to be corroborated with information from independent, external valuation experts, whose reports would be included in quarterly and annual reports. Making this data public, Schuetze said, would allow investors to understand the qualifications and source of the estimates.

“Would it cost more,” Schuetze said, “to prepare financial statements than it does nowadays if assets and liabilities were marked to market and issuers had to obtain separate reports from external auditors and external valuation experts? No doubt the answer to that question is yes.”

Schuetze estimates the annual cost of audits for 15,000 public companies under the mark-to-market scheme would be $20 billion to $30 billion, two to three times more than the cost of audits today.

“That increase in fees easily is absorbed just by the lost market capitalization of say 60 billion dollars by one Enron,” Schuetze said. Besides, he added, $20 billion is a “small price to pay” in comparison to the total market capitalization of the corporate stock and bond markets, which amounts to more than $20 trillion.