April 13, 2005
How Broken is the U.S. Accounting Profession?
Posted by Gordon Smith


For years I have been a modestly sympathetic observer of the accounting profession. My undergraduate major was in accounting at one of the top programs in the U.S., and I absorbed enough from that training to understand that accounting is as much art as science. As a result, I have tried to restrain myself from expecting too much from accountants. My patience is waning.

According to the W$J, the SEC will delay implementation of the stock option expensing rules again. This this time for six more months. The reason for the delay?

SEC staff members -- including Donald Nicolaisen, the agency's chief accountant, and Alan Beller, director of the SEC's division of corporation finance -- have been pressing for the change to allow more companies to devote additional time and resources toward understanding the new rules' complex requirements.

I will take this statement at face value and not assume the more cynical view that the SEC is a pawn for Silicon Valley companies who want Congress to change the stock option rules. This assumption merely transfers my cynicism to the accounting profession as I am forced to wonder: did accounting concepts become a lot harder since I graduated in 1986? Yes, I have looked at the stock option rules. And no, I am not an expert. But these rules have been bouncing around for years and some companies already expense stock options. Is it really plausible to claim that the rules are too complex?

Watching companies respond to these rules and the Section 404 provisions (mentioned in the same W$J story) reminds me that the accounting profession in the U.S. is severely challenged. The post-Enron reforms have undoubtedly imposed substantial new burdens on accountants, but the profession's response has been ... how shall I phrase this? ... unprofessional? You would think they would be more grateful in the wake of the biggest boon to the profession since the passage of the federal securities laws in the early 1930s. As it has become clearer that accountants are not providing the useful information that all of us were expecting, however, accountants have engaged in the time-honored strategy of whining about their lot in life.

The SEC is holding a Roundtable on Section 404 today. Based on the complaints about Section 404, you might have assumed that corporate managers and accountants were being asked to cure breast cancer or perform some equally heroic feat. No, companies have merely been asked to certify that they have an adequate system of internal controls for financial reporting, and to assess the effectiveness of that system. Note that companies have been required to have internal control systems since the enactment of the Foreign Corrupt Practices Act in 1977, so the only thing new here is the certification and assessment.

Also, note that an internal control system is not rocket science. Here is the SEC's definition, with some highlights from me:

A process designed by, or under the supervision of, the registrant’s principal executive and principal financial officers, or persons performing similar functions, and effected by the registrant’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:

(1) Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the registrant;

(2) Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and receipts and expenditures of the registrant are being made only in accordance with authorizations of management and directors of the registrant; and

(3) Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the registrant’s assets that could have a material effect on the financial statements.

Is this too much to ask? In an article published yesterday at Tech Central Station, Steve Bainbridge argues that Section 404 is too costly, especially for small businesses. I am sympathetic to his appeal to the SEC to "carv[e] out exemptions for smaller firms from the more burdensome aspects of SOX compliance," but let's not swallow the complaints of the accounting profession whole. The game is quite transparent: we want you to rely on financial statements, but don't blame us when things go wrong.

While I am open to suggestions -- like these from Larry Ribstein (or in a longer form here) -- about how Congress may have approached this issue in a different, less costly, way, I am disgusted at the inability of the accounting profession to provide reasonable assurance that the information they provide is based in reality.

</ rant>

UPDATE: Rants are usually sloppy around the edges and this one is no exception. It is no surprise, therefore, that Larry Ribstein and Steve Bainbridge were not fully persuaded on that first go-around. Perhaps I can clarify.

Larry argues (again) that SOX is misguided and hurts small companies. Under his story, the SEC is the "good guy" trying to minimize the costs of Congress' mistake.

Steve (citing Kim Krawiec) argues that the focus on internal control systems is misguided because courts and agencies cannot effectively monitor compliance. Regulating internal controls will lead to costly but ineffective measures.

Now my turn again. Let's remember that mine was a rant against the accounting profession (with the implication of complicity from the SEC), and that is not the same as a rallying cry for stock option expensing or SOX. My main complaint is pretty simple: accountants are dropping the ball, and the SEC is looking like an enabler rather than an enforcer.

With respect to stock option expensing, accountants claim that they need more time because the rule is complicated ... and the SEC gives them another extension. C'mon! I just don't find that plausible. I am not talking about the merits of expensing at all. This is a tough issue on the merits, and Larry argues forcefully against expensing. Nevertheless, given that expensing rules are in place, we can we expect more of the accounting profession than this.

With respect to internal controls, accountants claim that the costs associated with providing "reasonable assurance" that financial statements are reliable is astronomical. This sounds like a bad joke:

Accountants: "Here are the financial statements."
Investors: "Are they reliable?"
Accountants: "Oh, you want some assurance that they will be reliable? Well, that's going to cost something!"

As for the efficacy of internal control regulation, I don't see any reference to Section 404 in Kim's law review article. While the argument against has some superficial appeal, how do you explain the hundreds of companies that are unearthing problems with their financial statements because they are doing 404 reviews? We might conclude that the costs of reliability are too high -- or that this really isn't reliability -- but is there any doubt that 404 is turning up problems that previously were left uncovered?

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» Gordon Smith on Section 404 and options expensing from Ideoblog ...
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» The problem with internal controls from ProfessorBainbridge.com ...
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» Gordon Smith on Section 404 and options expensing from Ideoblog ...
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Comments (5)

1. Posted by Brian on April 13, 2005 @ 15:21 | Permalink

I'm surprised that these companies keep devoting effort to fighting this rule. The information is already available in the footnotes. Analysts read footnotes. The options info is already incorporated in stock prices. Moving the number from the footnotes to the income statement should not affect the stock price.

I'd modify your description of the game somewhat. The accountants' position is that we want you to rely on the financial statements but don't be stupid about it. We use the phrase "reasonable assurance" rather than the word "guarantee" for a reason. It is not feasible to design an I/C system that can prevent a determined group of execs from getting fraudulent financial statements published.

If you want a guarantee, hire an insurance company, not an accountant.

2. Posted by Gordon Smith on April 13, 2005 @ 15:48 | Permalink

Fair point, Brian, and I assume that it is the prospect of acting as insurers that is escalating the costs. My very uncharitable description of accountants leaves out an important aspect of the problem (which I was thinking about, but didn't write because the post was already turning into a law review article), namely, that accountants are concerned about liability. Although I doubt that we will see massive and widespread imposition of auditor liability, even a small possibility can create strong incentives to erect expensive safeguards.

3. Posted by Ruud Pruijm on April 14, 2005 @ 1:45 | Permalink

In my opinion, the main problem with the internal control regulation in Sox 404 is the implementation, not the law itself.
The SEC has written a very elaborate rule to define the exact meaning and scope of internal control (86 pages). The PCAOB has written a auditing standard of 161 pages, to describe the activities the auditors have to perform to evaluate the effectiveness of internal controls.
Gordon says "Is this too much to ask?"
Yes it is.
First: All this leads to much more work for a company. It must maintain detailed and auditable evidential matter, including documentation, to provide reasonable support for management's assessment of the effectiveness of the company's internal control over financial reporting.
Nearly all of the necessary documentation has to written from scratch, following the new internal control guidelines.
Second: the auditor has to perform much more work in order to audit the implementation of the requirements (60% of normal audit hours).
Third: The documentation has to be maintained and updated for every change in the business internal environment.

4. Posted by Gordon Smith on April 14, 2005 @ 6:33 | Permalink

Actually, Ruud, I asked whether it was too much to ask for "reasonable assurance" that financial statements are reliable, not whether the SEC's implementation rules are reasonable. Larry (in his updated post) argues that "reasonable assurance" is too much to ask. I disagree.

I suspect that you are probably right that the SEC went overboard in implementing Section 404. At least that is consistent with other stories I have heard told. If that is true, but "reasonable assurance" is still a worthwhile standard, then we deal with the implementation problem. Not necessarily simple, but a much different line of attack than ditching the "reasonable assurance" quest altogether.

5. Posted by Andrew Wallace on April 16, 2005 @ 13:52 | Permalink

Gordon, don't let them back you down. I think your original accounting instincts are correct. I have some but limited accounting knowledge and a bit more political knowledge on how these decisions are actually made.

Accounting: Giving away stock at below market value costs something. Maybe it is hard to value but so is a complex derivative contract and many other business expenses (see accounting art v. science). Giving away stock (and diluting investor shares) off the books is hard to defend, so we see much criticism based on complex regulations and clumsy bureaucrats. This line of reasoing instinctively attracts the libertarian-minded to the issue. However, I think they need to put this in the larger political context.

Politics: Company executives who want stock options have a clear incentive not to expense. If they do they get fewer options. Congress has blocked the rule before at their behest, and that is why the SEC and FASB have been going very slowly since. With corporate/accounting scandal off the front pages, Congress is not afraid to try to delay/kill/alter again, especially if the regs can be portrayed as "sudden shock" and "uncertain." "Let's stike the rules and substitute a study," they'll say.

The anti-expensers major obstacle appears to be Senate Banking Chrm. Shelby, but he could be rolled by a majority like anyone else. Someone higher up (House, Senate, or Bush admin leadership) would have to take a stand on principle (and accounting principles are not well understood by those outside the field).

Corporate lobbyists work for increased revenue for their companies. This is an issue where they work for even more direct and clear benefits than usual(free-lunch stock options, as opposed to streamlined regs, or a gov't contract) for their immediate supervisors, and often themselves personally. They go full bore for this one because the payoff is large and personal.

The SEC/FASB accountants know this, but remember, they are subordinates to the higher political leadership. The delay is in response to heavy lobbying. I sort of feel sorry for them, and see this as a interesting case study of lobbyist rent-seeking. Maybe that's cynical-sounding, but that doesn't make it untrue.

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