Category Archives: The Accounting Standard Setting Process

First, a joke (disclaimer: I didn’t write this, but found it here):

There are two sides to a bank’s balance sheet – the left side and the right side.
The problem is that, on the left side, there is nothing right,
and on the right side, there is nothing left!

This joke may be hilarious now, but a few years ago, not many bankers were laughing.  In 2007 and 2008, banks were watching as their marketable securities (more specifically, mortgage-backed securities) were adjusted to market value (mark-to-market pricing). These adjustments were resulting in serious, unexpected losses for banks.  The bank’s “valuable” securities were not so valuable anymore.  To balance the balance sheet (as assets decrease, so must liabilities), banks started loaning less (aka “credit crunch”).  Furthermore, lenders who were given MBS as collateral wanted their money back from banks (these MBS investments were not looking so prosperous anymore).  We all know the end to this story (think Lehman Brothers and a global financial crisis).

In a boom, mark-to-market pricing is great as it increases the “real” value of a bank’s (or, say homeowner’s) investments.  But in a bust, the value of these assets falls very quickly.  Why didn’t accountants catch this? Why weren’t financial analysts with their fancy models shouting warnings?

Because these people are human, and sometimes humans see one thing, but choose to believe another.   The title of Steve Lohr’s New York Times article enforces this idea: “In Modeling Risk, the Human Factor was Left Out.”

As long as there are people who want to make money, but not lose it, there will be bubbles and financial crises — even if we have the models to “predict” them.  Emanuel Derman states in the article, “The models were more a tool of enthusiasm than a cause of the crisis.”  The very models that should have implied, “things are going to get bad!” people interpreted as, “quick, make as much money as you can while things are good!” As the article states, in the good times, Wall Street will chase profits.

Andrew Lo, director of M.I.T. Laboratory for Financial Engineering, suggests more restraint, and better regulation, could have helped smooth the impact of the bursting housing bubble.

Perhaps a history lesson would have, too.  Before Wall Street ever had sophisticated models – in fact, before there was “Wall Street” – humans were creating bubbles.  For example, the Tulip bubble in Holland in the 1630s and the South Sea bubble in England in the 1790s.  During the Tulip Mania, tulip bulbs were so valuable the Dutch would trade 12 sheep (a valuable asset) for just one bulb.  (Substitute “tulip bulbs” with “real estate,” and “12 sheep” with “more borrowed money than you can afford to pay back,” and you have the same scenario today.)

So who is to blame?  Accountants, hedge fund managers, bankers, analysts, homeowners?  Try blaming mankind itself; as long as there are humans, there are going to be accountants who mark-to-market, hedge fund managers who short sell and homeowners who borrow more than they should. And there will always be another bubble (bonds anyone?).

The whole issue of not choosing to honors gift cards of customers may turn out to be a serious one, especially if this continues to be a trend for companies filing for bankruptcy. The most worrying factor in the whole issue is that why is there no regulation or law that disallows companies from doing so. There should be absolutely no scope for any company to decide that it will not redeem the gift cards.

I somehow get the idea that Jim Babb, the spokesperson of Circuit City almost expected applause when he made the statement that Circuit City would honor all gift cards irrespective of when they were bought. To begin with, it is the obligation of the company to honor all gift cards. Forget the law and all the possible accounting standards we could introduce, but is there anything that the consumer or customer has done to fight this. How about a consumer forum where customers can join forces, voice their opinions and ensure that the concerned governing bodies take action against such companies? These distressed customers probably still won’t be able to get anything out of their existing cards but they can save millions of other customers from being cheated in the future and prevent companies from taking this so lightly.

Now coming back to accounting, I definitely feel that FASB should introduce some standard or guideline to accommodate or better still treat these customers with valid gift cards as creditors of the company (or something on those lines), in the near future. Clearly this is a loop hole that companies have been taking advantage of, it has to be stopped and stopped soon.

As retailers sell more gift cards consumers are losing out. There are some major retailer which have gone bankrupt due to mismanagement and consumers who had purchase gift cards of those companies would have a very difficult time to claim that money back. Most consumers gives up on the process and does not proceed to the bankruptcy court.

Gift cards should be redeemable regardless of bankruptcy. It should be accounted in the company’s financial so that it will allocate a portion of goods or money just for Gift Cards. If a company is about to go bankrupt, it should allocate some resources for giftcard refunds or if the customer wants to let them purchase items until the actual closing of the store. Then during bankrupcty ruling, customers with gift cards should be able to send in their cards to redeem the cash spend to purchase it. Thus retail company should have an amount of money set aside if it is moving towards bankruptcy.

The use of third party sites to facilitate the exchange of gift cards is a very good idea because this will help those who do not see a need to use giftcards that they have to exchange with someone else for a more useful giftcard. These websites will decrease the effect of consumers not spending their gift cards as well as consumers losing out when retailers bankrupt.

While I agree with Justin’s initial statement about the impersonal nature of gift card giving, another aspect of the article caught my attention.  Toward the end of the article, Brian Riley (senior analyst with TowerGroup) was credited for saying that “a large part of the problem is that the accounting practices regarding the sale and redemption of gift cards by retailers are not standardized.”  This line piqued my curiosity to look at how retailers account for gift cards.  I turned to an article in the CPA Journal Online from November 2007 entitled “Gift Cards and Financial Reporting: Unwrapping the Uncertainties of Revenue-Recognition and Other Issues” by Ronald E. Marden and Timothy B. Forsyth — http://www.nysscpa.org/cpajournal/2007/1107/essentials/p28.htm.

This article digs a little deeper into the question of breakage income – at what point can the company decide that the card will not be used and can, therefore, be recognized as income. The article discusses the practices of big companies and cites the examples of as Best Buy, Home Depot, Circuit City, and Wal-Mart. Each of these retailers has a different system, outlined in their financial statements’ footnotes.

In the end, the article’s authors recommend that companies recognize breakage income based on “prior experience provides substantial evidence that cards meeting certain criteria will never be fully redeemed.” Ultimately, the authors strongly suggest that FASB take action on this issue and I agree.

As we have discussed in class, Hurricane Katrina was classified as “ordinary” for accounting purposes because hurricanes are not infrequent in Louisiana.  The article points out that it is nearly impossible to classify something as infrequent noting that:

One accounting textbook terms them “so restrictive” that they can include only “such items as a single chemist who knew the secret formula for an enterprise’s mixing solution but was eaten by a tiger on a big game hunt or a plant facility that was smashed by a meteor.”

It does make sense to make it very difficult to classifying events as “extraordinary.”  If it was easy, managers would likely manipulated financial statements as users often ignore “extraordinary items” as one time charges unlikely to be repeated.

While hurricanes to occur in Louisiana, I think that Katrina can still be classified as extraordinary due to what occurred after the hurricane passed.  Katrina in itself, I will acknowledge, should not be classified as extraordinary.  One can argue that it was the aftermath of Katrina, and the controversy surrounding the handling of the disaster, that can be classified as extraordinary.  Perhaps the delays in clean up, and the demographic shift of people out of New Orleans, had a more long term financial effect on the city.

The article “Yahoo, Google and Accounting — Web-Search Powerhouses Count Revenue Differently, Making Valuation a Chore” deals with the different methods Yahoo and Google use to report their revenues. In particular, Yahoo and Google treat revenue from small-text advertisements that they place on other companies’ Web sites differently.

Both companies act as technological intermediaries and quasi-advertising agencies, bringing together Web publishers and advertisers. They get paid each time an Internet user clicks on an ad, then give some of that money to the Web publisher on whose site the ad appeared.

Yahoo reports its revenues using the gross method (counting its payment to the publisher as an expense, labeled as a “traffic acquisition cost”), whereas Google only reports the net amount  (after it pays the Web publisher).

Using the gross method enables Yahoo to inflate its revenues and to appear faster growing (revenues grew 168%). If Yahoo had used the net method revenues grew only 94%. In Google’s case it is exactly the other way round. However, when it comes to gross profits, Yahoo’s profits appear smaller whereas Google’s profits appear larger.

I know we touched on this a little on class when discussing how to create an income statement, but it still seems a little crazy that 9/11 is not deemed an extraordinary by accounting standards.  While we deem those extraordinary items as infrequent and unusual (which 9/11 seems to be), the FASB’s final decision makes more sense when thinking from an accounting perspective.  The real world and the accounting world are two separate things and that is important to remember.

The thing that made this article confusing is that the FASB’s Emerging Issues Task Force decided 9/11 was extraordinary and then a week later decided just the opposite.  It really shows this is one of those easily debatable issues, which means no matter what FASB decided there were going to people on the other end that were going to be upset.

The quote from task-force member Dick Stock helped me to better understand the reasoning behind FASB’s change of heart.  Mr. Stock said that 9/11 affected almost every company and created such a broad new economic landscape that, “it almost made it ordinary.”  If most or all companies are going to have financial issues, everyone is going to be on a similar playing field so creating an extraordinary item line is not necessary.  It’s hard to envision many, if any other scenarios where ALL companies are affected.  This makes it harder as well because there is really no precedent to work off of.

The last paragraph is similar to what I thinking when I read the quote from Mr. Stock.  Although 9/11 did affect our entire economy, it definitely had a much larger impact on some companies as opposed to others.  We have no way of figuring out what that exact effect is (or more importantly what the company believes it is) and that means investors have to try and figure out individually what they believe the impact was.

The growing number of companies with Internet activities has prompted the SEC to address accounting for these activities already in October 1999. The SEC Chief Accountant back then, Lynn Turner, sent a letter to the FASB director of research and technical activities requesting that FASB consider a number of issues related to accounting for Internet activities. But have new specific guidelines been provided?

One issue related to accounting for Internet activities is the choice between using gross versus net revenue and cost display. This issue is still open to the company interpretation. Should companies report the amount received from the end-user as revenue and the amount paid to the supplier as cost of sales (expense), or report just the net amount as revenue (as if that amount were a commission paid by the supplier for generating a sale)? Those two methods are different in their essence: Gross reporting treats the transaction as the company purchasing a product or service from the supplier and then selling that product or service to the end-user while net reporting relates to the transaction as the end-user making a purchase from the supplier with the company acting as a sales agent. In order to make this determination there is a need to evaluate the relationships between the supplier, the company and the end customer.

The same logic is used for the case of Yahoo and Google: the proper accounting method depends on the company’s perception of its business. Is the company acting as an “agent” for a deal, or as a “principal” taking the risk to lose money?

It seems to me a bit absurd that FASB leaves this issue open to the personal interpretation of companies. For FASB, as long as a company keeps consistency in its reporting method, the company is following the principles. However, this situation of diversity in practice confuses investors and other financial statements users. I think that FASB should provide additional, specific guidance on the issue, guidance that will result in consistency and unity and won’t leave room for personal interpretations. A situation like that would improve the financial information presented and make the life of investors easier.