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Barron's: Schuetze's Suggestions

May 31

Written by: Jack Ciesielski
5/31/2005 7:46 AM

Guest editorialist Walter P. Schuetze put his thoughts to paper in this weekend's Barron's (subscription required) and made a number of useful points.

I've known Walter for a number of years and I think highly of him and his opinions. He's got quite a resume, including stints as a FASB board member and the SEC's chief accountant. I can't say I agree with everything in his editorial, however.

Walter's complaint - and a good one at that - is that financial statements aren't as reliable as other familiar items. The power tool that you plug into the wall isn't going to electrocute you because the manufacturer has lived up to Underwriters' Laboratory standards. Kellogg's corn flakes are safe to eat because they've been around for years and presumably, they haven't harmed anyone yet. In short, most products are fit for intended use. Except financial statements.

Walter believes that financial statements are far too wedded to historical cost rather than reflecting fair values of assets and liabilities. True enough, and I agree with that premise - but up to a point. Walter bemoans the fact that there are "surprise, elephant-size write-offs of accounts receivable, loans receivable, inventory, fixed assets, deferred tax assets (does anybody other than an FASB accountant know what a deferred tax asset is?), and goodwill that follow earnings management like a dog follows its master, and the huge declines in the market prices of the stock of the reporting corporations that follow write-offs like a tail follows the dog."

Sure, there are write-offs. Those write-offs should occur when something has happened to change their value; when there's an impairment to an asset, a charge (writedown) ought to happen immediately. It's part of making the financial statements show what assets are worth - bringing them closer to fair value - and showing what happened in a given period. The fact that the writedowns have occurred doesn't mean financial reporting isn't doing the job it's intended to do - the real question might be why they don't occur sooner.

Where I think my view differs from Walter's the most is in this passage:

"... today's financial statements and reports are so complex and arcane as to be incomprehensible. Beyond lack of clarity, financial statements and reports as we know them today affirmatively mislead investors, who are their consumers. Such financial statements and reports are not "fit for their intended use."

Retail investors do not understand today's financial statements and reports, which are based on generally accepted accounting principles issued by the Financial Accounting Standards Board. Nor do many institutional investors. Nor do men and women in Congress, which became obvious during the congressional hearings about Enron and WorldCom a couple of years ago. What they do not understand, they cannot use."

I do not believe for one moment that "today's financial statements and reports are so complex and arcane as to be incomprehensible." I believe that the transactions in which firms engage themselves are indeed complex and border on the incomprehensible and that is what financial reporting is reporting. Don't confuse the messenger with the message.

Can the message in the financial statements be sorted out? Yes, by those willing to invest the time and effort to do so. And that's the way capitalism works: you want the rewards, you put in the effort. Should "retail investors ... understand today's financial statements and reports?" If they're willing to put in the effort to understand them, yes. Should financial statements and reports of complex organizations involved with complex transactions be transformed into something they really aren't ("Financial Statements for Dummies?") just to find a lowest common denominator? I don't think so; I don't think that's making financial statements tell the true story. I sometimes wish I'd been a brain surgeon, but the coursework was too hard. (So I became an accounting analyst.) Should brain surgery be easier to accommodate guys like me? I don't think so. But if I ever need a brain doc, I'll find one who completed his schooling. (I know, I know: go see one now.) If retail investors can't understand financial statements, then they should find a broker or mutual fund they trust.

Do investment professionals really understand the financials? Sometimes. Is it the fault of the financial reporting system? I don't think so. I think there's a real aversion in most people in getting down to detail work, and that's what digging through financial statements is all about. You find that you don't "get" everything the first time you encounter it, you feel dumb, and you don't always want to doubt your capacities. Some folks dust themselves off and make themselves find out what they don't know. I think the vast majority find it easier to slough the work and say that the accounting isn't important because it's all backward-looking or it's already in the price of the stock because everyone else read it or interest rate changes are far more important or accounting is the province of geeks. Or some other excuse. A lot of this is ingrained into investment professionals' thinking as they go through B-school; we're just not brought up to believe that accounting and financial statements are terribly important. Better to diversify, so you don't wind up getting hit too hard should one of the companies you own bomb out. (It's funny how diligently some people will study financial statements after that's happened.)

I digress. Back to Walter's editorial. Walter suggests that "financial statement numbers be based on market values prepared by independent experts who know about markets and market prices." Auditors would attest to accounting, and leave the valuation stuff to experts. No management control over valuation issues.

Sounds good at first. Think about it more and there are some issues bubbling to the surface. Right now - and more than ever, post-SOX - financial statements are the assertion and responsibility of management. If a scenario like this one ever developed - who'd be truly responsible for the financial statements? Management could point the finger at the valuation experts when something goes wrong. Valuation experts might try to offload blame onto the auditors. And another thing: who's paying the valuation experts for their opinion? This opens up another whole can of worms labeled "independence." I think we're better off having management stay responsible for all of the financial statements and improving the disclosures so that they can be held accountable by their owners and the markets.

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Pension & Other Benefit Plans: A Look Ahead

Investors in firms with defined benefit pension plans always face the risk of suddenly being pushed farther back in line when it comes to being served their returns. Variability in plan assets and variability in benefit plan obligations are the reason: poor asset returns coupled with sinking interest rates always spell tough times for defined benefit plan funding. In that regard, this year’s asset returns combined with the Fed’s “Operation Twist” add up to “Operation Agony” for defined benefit pension plans. If trends continue along their current path, firms that may have anticipated moving to more realistic pension accounting - like Honeywell, AT&T and Verizon already have done - might forego that decision. It could be just too painful.

Pensions aren’t the only kind of benefit plan affected by Operation Twist. Other postemployment benefit (OPEB) plans share much the same accounting model as pensions, including the calculation of a projected benefit obligation that similarly incorporates a discount rate - one that will also be affected by Operation Twist. The net OPEB obligations were slightly less than pension obligations at the end of 2010, but also promise to grow in 2011. Investors perceive them as less threatening than pension obligations because they don’t require funding. Strangely, there are a number of firms that are recognizing income from these benefit plans - without ever creating a dime of cash for investors.

A recent edition of The Analyst’s Accounting Observer dissects these issues, and is available only to paid subscribers. A condensed version is available for free upon request. To receive it, send an e-mail to Brenda Rappold at brappold@accountingobserver.com, with “PENSIONS” in the subject line.

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