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U.S. Accounting Standards and Their Environment:
A Dualistic Study of Their 75 Years of Change
I. Past Changes: Theme 1: The First Market Crash and the Second Market Crash
Theme 2: Facts-Based Accounting and Forecasts-Based Accounting
II. ... Future Trends: Theme 5: Forecast Protection and Forecast Separation
Theme 6: Principles-Based Systems and Rules-Based Systems
In analyzing observations, I would like to adopt “dualistic views. ... Four years after the first market crash, the Securities Act of 1933 was
passed. ... Trueblood University Professor of Accounting and Economics, Graduate
School of Industrial Administration, Carnegie Mellon University, Pittsburgh, PA 15213, U.S. ... This
paper was prepared by the author translating into English, with minor modifications, from the draft of
his public lecture delivered in Japanese on June 24, 2003 in Tokyo under the sponsorship of the
Accounting Standards Board of Japan, Financial Accounting Standards Foundation, and all of its
Founding Member Organizations. The Japanese draft will be published in FASFs Accounting
Standards Quarterly, Volume 1, No. ... ), Eric Louis Kohler: Accounting’s Man of Principles, Reston
Publishing Co. ...
2
Likewise, in July 2002, two and a half years after the second market crash, a reform
bill on accounting and corporate governance was signed into law. This is considered to be the
most important legislation on securities transactions and accounting since the establishment of
the SEC. ... The fever he mentioned
appeared in exactly the same manner 70 years from the first market crash. ... In
2 years and 4 months, the per-capita loss amounted to $30,000. ... In 1929 and in 2000, accounting became the scapegoat.
There is no question that accounting was responsible in part. However, too many people want
to believe that reforming accounting alone is enough to prevent the recurrence of the event. ... It could occur in a time-frame much
shorter than 70 years between the first and the second fevers. This is because the epicenter of
the power that shakes the market is in the rapidity of the progress that the science and
technology have been making in recent years. ... 5
For example, in April 2003, after 13 years of study the human genome map was
completed with nearly 100% accuracy by an international science team. ...
6 The Human Genome Map Is Finished to an Accuracy of Nearly 100%, an International Scientific
Team Declared, Culminating 13 years of Work. ...
Theme 2: Facts-Based Accounting and Forecasts-Based Accounting
When we trace the history of accounting, a term we hit sooner or later is “Script”
which means “handwrite” or “faithfully reproduce. ... Historically, the foundation of accounting
was the recording of historical facts. In recent decades, modern accounting has produced
financial reports and peoples interest has largely moved toward these reports. ... Social contributions
of accounting records exist from the past, to the present and to the future continuously. ... I wish to reaffirm that the origin of
accounting is in the records. ...
Nevertheless, forecasts of transactions and balances, which may correspond to a
forecast of the next move in a chess game, crept into accounting, beginning around the start of
1970s. ... As a result, the “realization principle” became an accepted accounting principle,
superceding the cash principle, allowing for recognition of profit in the period of delivery. ...
“Reserve Recognition Accounting (RRA)” that was promoted by the SEC in the mid-
1970s for accounting in oil and gas and other extractive industries is a typical case of thirdlevel
early profit recognition. ... The change over the
beginning of the year would be an addition to the profit of the year, which is fourth-level early
profit recognition. ... Such a method of valuation of a corporation as a whole before
the company is actually sold has never been accepted in accounting in any country. ...
10 Jonathan Weil, After Enron, ‘Mark to Market’ Accounting Gets Scrutiny. ...
11 Greg Ip, Why High-Fliers, Built on Big Ideas, Are Such Fast Fallers: Life-Cycles Shrink for Firms
with Intangible Assets; Winstar’s 2-Year Tumble; ‘Trust Can Vanish Overnight. ...
5
However, accounting is like civil engineering, when it builds a bridge, it has to make sure that
the bridge can support the weight that will be placed on the bridge. ... There
is a phrase that expresses the essence of accounting in which forecasts are abundantly
included. ... 12” This seems to be also applicable to the fate of present-day
accounting. Viewed from the standpoint of the cash principle, the penalty for eating the
forbidden fruit called “early profit recognition” was to have accounting, and only accounting,
chased out of the “cash paradise.” The law and the public in general stay in the cash paradise
and criticize accounting. In their view, accounting is like counting money or “beans,” a
simple task indeed, and any errors are due to accountants deliberate misrepresentations. ... The
forecasts requiring the longest period into the future relate to pension accounting. Suppose an
employee is hired at age 20, works for the company for 40 years, retires at 60, and receives a
pension for the next 40 years until his death at age 100. This employees pension expense
determination for the initial year of hiring requires forecasts 80 years into the future. ... Yet, this issue
somehow disappeared and standards emerged that legitimatized the forecasts as being fair
under the generally accepted accounting principles.
The SECs change in its view toward forecasts cannot be neglected as a contributing
cause for forecasts coming into accounting. ... 13 Yet starting in the 1970’s, the SEC changed its position 180 degrees to
promote forecasts.
In addition, the accountability and stewardship roles of accounting, emphasized in the
1930s have been lost over the years. They have been replaced by the view that the purpose of
accounting is to provide information useful for investors decisions. A significant example of
this movement was the American Accounting Associations monograph, A Statement of Basic
Accounting Theory.14 By the time the Financial Accounting Standards Board was established
in 1973, the report from the American Institute of Certified Public Accountants’ Objectives
Study Group had also been published, promoting the view that “if information is useful for
investors, it should be provided even if it is somewhat subjective,” a view that gradually
prevailed in the accounting practice.
Needless to say, if there is early profit recognition, there is also early “loss”
recognition, but in the normal economic environment, most companies earn profits. ...
We can now define “facts-based accounting” to mean accounting that is consistent
with the SECs old attitude that allows only historical facts, and “forecasts-based accounting”
to mean accounting that is in line with the SECs new attitude that welcomes forecasts. Thus,
the biggest change that has occurred between the first market crash and the second market
crash is the shift in accounting from facts-based accounting to forecasts-based accounting.
In addition, there is an important point to observe in the latter part of the 75 year
period. That is, accounting is a surrogate that represents economic reality. However, as
accounting has changed in the way mentioned above, the reality seems to have changed, too. ...
14 American Accounting Association, A Statement of Basic Accounting Theory. Sarasota, FL: American
Accounting Association, 1966. ...
Beginning around 1980, another change in the reality stems from the widespread use
of stock options as management compensation, amplifying the incentive to manipulate
earnings many times compared with bonuses. Then, it became obvious that forecasts-based
accounting was much easier to manipulate than facts-based accounting. In other words,
forecasts-based accounting itself might not have promoted the series of manipulation. But if
forecasts-based accounting is viewed as “oil,” what served as the “matches” are the bonuses
and stock options that are linked directly or indirectly with profit. ... In fact many
investors rely too much on accounting numbers, seemingly unaware that financial statements
now include many forecasts of larger magnitude. ...
(By the way, the Japanese word for “prediction” is “yo-so-u.” Someone found that the
reversal of it means “It’s a lie!” The same for “forecasts” is “yo-so-ku,” whose reversal means
"It’s waste! ... 15” Listing items that have direct impact on accounting, the
Reform Act established under the SEC a five member board called the “Public Company
Accounting Oversight Board” and gave it the power to review problems related to accounting
and punish misbehavior. ... 18 The lead audit partner and reviewing partner
of a client engagement must change every five years. ... Public Company Accounting Oversight Board. ...
7
Act, there was a consideration on requiring companies to “rotate” the audit firm every 5 years,
but this was later dropped.20
The Reform Act requires a company’s Chief Executive Officer (CEO) and Chief
Financial Officer (CFO) to certify under oath the accuracy of annual and quarterly reports as
well as other financial documents filed with the SEC. ... The penalty for destroying or altering documents to
obstruct investigation by the federal government is also a maximum 20-year imprisonment
and for destroying documents and emails of financial audits (that are required to be kept for 5
years), the penalty is a maximum 10-year imprisonment.23
Now consider the importance of certification under oath along with forecasts-based
accounting. ... The certification requirement may make sense under facts-based accounting. But
under forecasts-based accounting, this imposes significant litigation risk on executives. ... 24 At
about that time, Michael Oxley, Chairman of the Financial Services Committee of the House,
led the efforts to develop a reform bill on accounting and corporate governance. ...
24 Rebecca Smith and Mitchell Pacelle, Enron Files for Chapter 11 Bankruptcy, Sues Dynegy:
Proceeding Is Biggest Ever In the U.S. ...
25 Michael Schroeder, House, in Bipartisan Vote, Backs Moderate Accounting Overhaul. ... 34
The Reform Act applies to foreign corporations listed on the U.S. ... In particular, corporations from
European Union countries strongly argued that if U.S. has the power to regulate EU
corporations, then the EU should have the power to regulate U.S. ... The point of
issue is the regulation of U.S. ... The Japanese Institute of CPAs
President wrote to his U.S. counterpart in August 2002, saying that the Reform Act would
“place U.S. ... The biggest change that was brought about by the Reform Act is, as
mentioned above, that the accounting profession which had been left to their self-regulation is
now under the SECs newly established oversight body, the Public Company Accounting
Oversight Board. ... S. ...
35 EU May Protest U.S. Accounting-Reform Bill. ... Delaney, Craig Karmin, and Phillip Day, Corporate Cleanup Stings Foreigners: New Law
Scours Practices of Firms Trading in U.S. ...
37 Deborah Solomon and Cassell Bryan-Low, ‘Tough’ Cop for Accounting Beat. ... Especially as
examined in Theme 2, forecasts have now been abundantly observed in accounting. ... Also from the
fact that the Reform Act increased the statute of limitation from 3 years to 5 years, it is safe to
predict that the Reform Act will produce a significant increase in investor litigation. ... There’s no doubt about that. ... It is the fairness phrase that accountants have developed over
many decades, namely, it is not a certification of pure fairness but a certification of fairness
“under generally accepted accounting principles. ... In the famous Continental Vending Machine
Corporation case, the Appellate court concluded that “Generally accepted accounting
principles instruct an accountant what to do in the usual case where he has no reason to doubt
that the affairs of the corporation are being honestly conducted. ...
44 U.S. ... 2d 796; 1969 U.S. ...
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considered to be sufficient to follow GAAP fairness which is based on the professions
standards. ... While the Appellate court’s statement may sound reasonable, the trouble is that it
struck down GAAP without showing where the new limit of responsibilities are for the
auditor. ...
Therefore, some members of the accounting group at Carnegie Mellon Universitys
Graduate School of Industrial Administration, started a project to separate facts and forecasts
in two columns of financial statements along with the total column. ...
45 Steve Liesman, SEC Accounting Cop’s Warning: Playing by Rules May Not Ward Off Fraud Issues. ... They are presented like branch office accounting,
with a head office column and a branch office column, each balancing on their own. ...
Instead of the geographical separation of the two columns in branch accounting, we have a
temporal separation between the facts column and the forecasts column, hence we call the
new method “intertemporal accounting” in a manner analogous to “intercompany
accounting. ... When an item in a forecast account has
to be moved to a fact account by the passage of time, this is done likewise as observed in
branch office accounting. ... Lundholm, Reporting on the Past: A New Approach to Improving Accounting Today,
Accounting Horizons, December 1999, pp. ... Dichev, The
Quality of Accruals and Earnings: The Role of Accrual Estimation Errors, The Accounting Review,
Supplement 2002, pp. ... Such possibilities
seem to have been increased when the SEC took steps to propose “Managements’ Discussion
and Analysis (MD&A) disclosure of the applications of critical accounting policies.
Approximate Word count = 10676
Approximate Pages = 42.7
(250 words per page double spaced)
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