Contemporary Issues in Financial Reporting A user-oriented approach

Paul Rosenfield

Routledge New Works in Ac

Contemporary Issues in Financial Report ing

With the collapse of Enron in 2001, and other similar scandals, financial reporting and its relation to corporate governance has become a contentious issue. In this book Paul Rosenfield involves the reader in exploring contemporary financial reporting, highlighting the deficiencies in current methods.

Contemporary Issues in Financial Reporting challenges the reader to critically think through the issues and arguments involved in the practice of financial reporting. The book goes to the heart of the most difficult and controversial problems, presenting the major issues and commenting upon the solutions that have been offered in the financial reporting literature. The grave defects in current accepted accounting principles are demonstrated and exposed, and Paul Rosenfield offers alternative solutions.

Paul Rosenfield is a CPA for the state of Illinois and worked for the AlCPA for 30 years, during which time he was Director of the Institute's Account­ing Standards Division. He taught financial reporting at Hunter College, New York, and has published widely on the subject, including co-editing the tenth edition of the Accountants' Handbook (2003).

Accounting students and professors, as well as regulators and account­ing professionals in firms and companies, can profit immensely from this refreshing and fearless analysis of the major issues of the day in financial reporting. ^

Stephen A. Zeff, Herbert S. Autrey Professor of Accounting at Rice University, USA

Routledge new works in accounting history Edited by Garry Carnegie (Melbourne University Private, Australia), John Richard Edwards (Cardiff University, UK), Salvador Carmona (Insti­tute de Empresa, Spain) and Dick Fleischman (John Carroll University, USA).

1 The Institute of Accounts Nineteenth-century origins of accounting professionalism in the United States Stephen E. Loeb and Paul J, Miranti.Jr

2 Professionalism and Accounting Rules Brian P. West

3 Accounting Theory Essays by Carl Thomas Devine Edited by Harvey S. Hendrickson and Paul F. Williams

4 Mark to Market Accounting "True North" in financial reporting Walter P. Schuetze. edited by Peter W. Wolnizer

5 A History of Auditing f-The changing audit process in Britain from the nineteenth century to the present day Derek Matthews

6 Contemporary Issues in Financial Reporting A user-oriented approach Paul Rosenfield

Contemporary Issues in Financial Reporting A user-oriented approacli

Paul Rosenfield

O Routledge g ^ k Taylor 6i Francis Croup

LONDON AND NEW YORK

First published 2006 by Routledge 2 Park Square, Milton Park, Abingdon, Oxon O X 1 4 4 R N

Simultaneously published in the USA and Canada by Routledge 270 Madison Ave, New York, NY 10016

Routledge is an imprint of the Taylor & Francis Group, an informa business

Transferted to Digital Printing 2008

© 2006 Paul Rosenfield

Typeset in Garamond by Wearset Ltd, Boldon, Tyne and Wear

All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers.

British Library Cataloguing in Publication Data A catalogue record for this book is available from the British Library

Library of Congress Cataloging in Publication Data A catalog record for this book has been requested

ISBNIO: 0-415-70206-2 (hbk) ISBNIO: 0-203-08815-8 (ebk) ISBNIO: 0-415-77642-2 (pbk)

ISBN13: 978-0-415-70206-5 (hbk) ISBN13: 978-0-203-08815-9 (ebk) ISBN13: 978-0-415-77642-4 (pbk)

To my children Mark, Keith, Valerie, Brian, and Kevin, with love

. . . the betterment of accounting must begin in the classroom . . . our undergraduate curricula consist almost entirely of present practices. . . . The undergraduates go into practice and implement what we taught them; the graduate students go into academia and advance the research; the gap between research and practice grows wider and wider. Young and rising accounting practitioners cannot view both sides of the ques­tion with impartiality because we teachers do not present both sides of the question. Instead, we pass along and thereby reinforce the inherited dogma. Thus, the long-run reform of accounting practice requires the reform of accounting curricula. My suggestion is that we teach both— we consider alternatives to present practices with the description of present practices.

(Sterling, 1989,82; 1979, x)

. . . students . . . are being sent out into a world where they will be leaders in 20 years more or less; but in that time it will be a different world. How are they equipped to meet that . . . knowing only the current dogma of their time? . . . the teacher . . . should . . . present the very best of what is being done in . . . the studies of the researchers, for there is a distinct probability that some of it, heresy today, will become orthodox and accepted in practice in the students' lifetimes. . . . To be in the vanguard of advances in knowledge and technology is at once a duty and a source of deep satisfaction to educators.

(Chambers, 1969, 691, 692; 1987, 106)

. . . [to] provide students not just with a knowledge of current practice, but with the knowledge to evaluate critically that practice and seek its reform.

(West, 2003, 162)

. . . teaching little except GAAP not only neglects the investing public but may also prepare students poorly for long-run careers, because critical thinking is so important in some the high positions in the profession.

(Staubus, 2004b)

Contents

List of figures xiv List of tables • xv Foreword xvi Preface xviii Acknowledgments xxii Note on assignments xxiii

Pro logue: t h i n k i n g i n d e p e n d e n t l y 1

PART I Set t ing the stage 25

1 The nature of financial reporting 27

Issuers and users 21

Functions of records and reports 28

Financial reporting as mapping 32

Venture reporting versus time period reporting 33

Financial accounting versus financial reporting 35

Functions of bookkeeping, accounting, and financial reporting 31

Financial statements versus economics 39

Financial reporting versus financial analysis 39

Financial reporting versus income tax accounting 40

A science or an art? 41

Discussion questions 41

2 The incentives of the parties to financial reporting 43

Positive and normative research 44

Conflicting incentives 46

Incentives of users 41

viii Contents

Incentives of issuers 48

Incentives of outside auditors 66 Incentives of citizens 10

Incentives of standard-setters and regulators 10 Incentives of elected government officials 11 Incentives of teachers of financial reporting 13 Discussion questions 14

3 Designing financial statements by starting with desired results or by applying analysis for the benefit of the users ' 5

Starting with desired results in designing financial statements 16 Applying analysis for the benefit of the users in designing financial

statements 83 Discussion questions 104 Appendix A: classes of events 104 Appendix B: current GAAP by classes of events 106

4 The indoctrination of financial reporters 118

Origin of the indoctrination of financial reporters 119 Manifestations of the indoctrination of financial reporters 121 Virginia and financial reporting 130 Discussion questions 131

PART 11 Issues underly ing financial report ing 133

5 Views on the desirability of stabilizing income reporting by the design of GAAP 135

Views of official organizations 135 Reasons that have been given in favor of stabilizing income reporting by

the design of GAAP 138 Reasons that have been given in opposition to stabilizing income

reporting by the design of GAAP 142 Conclusion on the desirability of stabilizing income reporting by the

design of GAAP 144 Lip service 146 Debating points 146

Contents ix

6 Measurement in the preparation of financial statements 147

Measurement, observation, quantification, and calculation 141

Time of measurement 149

Measurable attributes and units of measure 152

Defining the unit of measure in terms of the powers of money 152

Surrogate measures 154

Measurement and calculation in financial statements 155

Measurement and estimation in financial statements 156

Debating points 151

7 Historical report 159

Pertinent characteristics of time 160

Reflecting in financial statements the financial effects of supposed future

events I6l

Reflecting in flnancial statements current conditions that indirectly

involve the future 112

Reflecting in financial statements the financial effects of events that

might have occurred but didn't 118

Going concern 180

Debating points 181

8 The focus of attention in financial reporting 183

A handy fiction? 183

Selection of the reporting entity as classification 184

The original focus of attention 184

The incomplete evolution of the concept of the focus of attention 185

Theories about the reporting entity 185

A complete evolution of the concept of the focus of attention 190

Debating points 200

9 The elements of the reporting entity represented in financial statements 201

Economic resources 202

Articulation 203

Definitions of the elements 204

A ccrual basis 215

Nonarticulation 218

Debating points 222

X Contents

PART III Broad issues in financial reporting ^^^

10 The current broad principles ^ •'

Statement of the current broad principles 228

Evaluation of the current broad principles 238

Conformity of the current broad principles with the incentives of the

issuers, outside auditors, standard-setters, and regulators 249

Financial reporting as ritual 255

Debating points 258

11 Inflation reporting 260

Defining the unit of measure in terms of general purchasing power 261

Inflation reporting and current value reporting 211

Inflation reporting and reporting on foreign operations 212

Debating points 212

12 Presenting discounted future cash receipts and payments in financial statements 273

The "ideal basis" 214

The existence of present value 215

The parentage of the concept 216

The magic of discounting 280

The reversal of cause and effect 281

Presenting solely the financial effects of supposed future events 282

Nonexistent future events 282

Conclusion on whether present value is a current condition of the

reporting entity 283

Appendix: the ultimate form of allocation 284

Debating points 285

13 Proposed broad principles for reporting on assets using current buying prices 286

Current buying prices 286

Presenting fiction 289

Using the price of an asset not owned or sold 293

Deprival value 291

Supplementary information on current buying prices 298

Debating points 299

Contents xi

14 Proposed broad principles for reporting on assets using current selling prices 300

The only current measurable financial attribute 301

Class A and Class B aspects 304 Reporting the Class A aspect and disclosing information concerning the

Class B aspect 305

CSPR and the user-oriented criteria 308

Evidence for the measurement of current selling prices 311

CSPR and stable income reporting—the foremost objection to

CSPR 314

Foremost conceptual objections to CSPR 315

Other conceptual objections to CSPR 319

Other practical objections to CSPR 325

Wishful thinking 328

Quiet appeal 328

Debating points 333

15 Current and proposed broad principles for reporting on liabilities 334

Events causing a liability to be incurred 335

Names of payments required 336

Events causing a liability to be discharged 336

Current broad principle for reporting on a liability 331

Proposed broad principles for reporting on a liability 340

Debating points 350

16 Reflecting or reporting prospects in financial statements 351

Reflecting prospects in flnancial statements 353

Reporting prospects in flnancial statements 355

Conclusion on reflecting or reporting prospects in flnancial

statements 362

Debating points 362

17 Disclosure in financial reporting 363

A tangle of trees 364

Information to help users evaluate current prospects 365

Investments in prospects 366

Supplementary information 366

Disclosure overload 313

xii Contents

Reporting in the flnancial statements versus disclosure in the notes 319

Debating points 319

PART IV Specific issues in financial report ing ^"^

18 Reporting in connection with stock options granted to employees 383

Round one 383 Round two 391 Debating points 398

19 Alternative financial statement reporting practices 399

Standard-setting and alternatives 399 Power to reduce alternatives 400

Alternatives reduced 401 Alternatives not reduced—notorious cases 402 Alternatives not reduced—other signiflcant areas 406

The users yawn 409 Debating points 410

20 Display on financial statements 411

Display on the balance sheet 411 Display on the statement of income 419 Display on the statement of cash flows 420 Debating points 421

21 Reporting on income taxes 422

Deferred taxes 424 Comprehensive interperiod income tax allocation 426 The rationale 421 The analysis 428 Net-of-tax 441 Earnings management 441 Debating points 441

22 Reporting on foreign operations 442

Four sets of translation rules 443 Catch-22 450

Contents xiii

Accounting for foreign operation 451

Reporting on foreign operations and inflation reporting 455

Debating points 451

23 Reporting after business combinations and on related goodwill 458

Requirements before the battle 458

The battle 461

Results of reporting after business combinations in conformity with

Opinions Nos 16 and 11 466

The new requirements 461

Reporting after business combinations to conform with the user-oriented

criteria 468

Debating points 411

24 Reporting on employee benefits 472

Reporting on deflned benefit pensions 412

Postretirement benefits other than pensions 484

Advance funding 481

Earnings management 481

Debating points 481

25 Reporting on leases and executory contracts 489

Capitalize all active noncancelable leases? 489

Definition of an executory contract 491

Capitalize all executory contracts? 492

Are active leases executory contracts? 493

Reporting on leases 494

Debating points 498

26 Consolidated financial statements 499

Should consolidated flnancial statements be presented? 500

Consolidation policy 501

A fictitious reporting entity? 503

Treatment of noncontrolling stockholdings 503

Debating points 506

Epilogue: the hijacking of GAAP 507

Appendix 513 Bibliography 5 17 Author index 546

Subject index 552