The Crisis in Financial Reporting

Rick Antle

Senior Associate Dean and Professor of Accounting

Yale School of Management

October 17, 2002 3

Criticized Parties

• Government regulators

• Standards’ setters (FASB & EITF)

• Management

• Boards of directors

• Accounting profession

October 17, 2002 4

Debacle

• A sudden, disastrous collapse, or defeat; a rout

October 17, 2002 5

Fiasco

• A complete failure

October 17, 2002 6

Failure

• Cessation of proper functioning or performance

October 17, 2002 7

“I am not an accountant.”

October 17, 2002 8

Basis of Financial Reporting

• Economic concepts

• Accounting conventions

• Institutional context

October 17, 2002 9

Accounting Identity

Assets = Liabilities + Equity

Assets – Liabilities = Equity

October 17, 2002 10

How it Works

• 0 – 0 = 0?

• 5 – 3 = 2?

• RECOGNITION CRITERIA!!

October 17, 2002 11

Building Example

• Original cost: $6 million

• Accumulated depreciation: $4 million

• Sales price: $3 million

• Does selling the building add to shareholders’ wealth?

October 17, 2002 12

I Am Not An Accountant

• Professes confusion of the aspirations of accounting with the practical results of applying its conventions and techniques.

October 17, 2002 13

Standards’ Setters

• FASB’s elaborate due process means:

Details and loopholes are there because someone wants them there.

• Just look at the treatment of executive stock options.

October 17, 2002 14

Special Purpose Entity - Problem

RiskyCorp

Wants to borrow $100 to build an office building, which it will occupy

OfficeCorp

A special purpose entity. Will issue debt, construct the office building, and lease it to Risky Corp

Big Bank

Loan

Payments(Interest rate?)

October 17, 2002 15

Special Purpose Entity - Consolidated

RiskyCorp

OfficeCorp

Big Bank

LoanPayments

Lease Payments

Use of office building

Risky Corp & Subsidiary

October 17, 2002 16

Special Purpose Entity - Off Balance Sheet

RiskyCorp

OfficeCorp

Big Bank

LoanPayments

Lease Payments

Use of office building

Outside investors

EquityDividends

Loan guarantee

October 17, 2002 17

Dialog One

• How about $0.1 of equity for Office Corp?

• Not enough? How about $0.02?

• Still not enough? Ok, you tell me, how much equity is enough?

October 17, 2002 18

Two Choices

• Don’t answer questions

• Pick a cut-off number or a rule for determining a cut-off number

• Pre-Enron, number was $3. Now I believe it is $10.

October 17, 2002 19

Not Feasible to Refuse to Answer

• Another dialog:

• How about $100 of equity?

• That will do it? Then how about $99?

• That’s OK, too? Then how about $98?

October 17, 2002 20

Categorizations

• Use of categories as a basis of aggregation is too handy to abandon.

• Requires methods for assigning things to categories.

• Creates the possibility of playing games to manipulate the classification.

October 17, 2002 21

Principles-Based Standards

• Some think less detailed rules are the answer.

• I think not.

• Rules for assigning things to categories fall somewhere in the following box:

October 17, 2002 22

Explicit Implicit

Uniform

Varied

Logical Possibilities for Classification Rules

October 17, 2002 23

Accounting Profession

During the recent past, however, the profession has not always lived up to its duties and responsibilities. …Because of the growing list of substandard audits, the profession is slowly losing its credibility…. We have seen too many recent instances of flawed accounting reports that simply have been chalked up to the overworked explanation that a certain amount of poor financial reporting is inevitable.

Judge Sporkin

October 17, 2002 24

Accounting Profession

We are not confronted with a liability crisis. We are instead confronted with an identity crisis. We don’t know for what, to whom, and the when of our responsibility.

Abraham Briloff

October 17, 2002 25

Profession’s Response

• Tightened internal control of Big 4

• Emergency response teams

• Pro-active – before the Public Company Accounting Oversight Board requires changes

October 17, 2002 26

You can’t regain credibilityby only doing things you arerequired to do.