Leading View Reflected in the Four Topics Under this Title
Neither investors, creditors, and their advisors are deeply concerned about the technical aspects of accounting questions, including those about alternative accounting procedures, as long as adequate information is disclosed about the method a company uses and related matters to enable them to adjust the reported results in ways they think necessary. In general, the more technical the question, the more likely they are to be largely indifferent to the arguments and concerned with adequate disclosure.
Note: All fifteen pages in this subcategory of the database except the last (excerpts of interview of a sell-side analyst and an article by French analysts) came from the Investors and Creditors Discussion Groups. The subject came up briefly in the discussion with investors 10/16/92, and the meeting materials and postmeeting questionnaires for the investors group meeting 12/9/92 and the creditors group meeting 2/2/93 asked specific questions about the desirability of eliminating managements' free choice of alternative accounting methods, such as FIFO and LIFO for inventories, straight-line and declining-charge methods for depreciation, successful-efforts and full-cost accounting for oil and gas companies, and trade-date and settlement-date accounting for securities firms. Meeting materials for the two groups differed, but the postmeeting questionnaires asked both groups the same questions.
The Leading view was readily apparent in the discussions and was confirmed by the postmeeting questionnaires. The two Alternative views also were expressed in the discussions, but their relative strengths were not evident until the responses to the questionnaires were analyzed.
Leading view
If the inventory or depreciation method a company uses is clearly disclosed, there is no reason to restrict management's choice of the method that is most appropriate for the company. Some would carry that view a step further, saying that companies should be able to choose the method, but choice of one should be accompanied by supplemental disclosure of results of applying the alternative method. The following are typical explanations given by those who favor the view just described: To analysts, differences in the companies they follow, even within the same industry, are reasons for different accounting methods, not reasons to require companies to standardize inventory or depreciation methods. Disclosure of the methods used and their effects is better in giving a level-playing field than standardization of accounting method [p. 3] Each analyst prefers to make his or her own adjustments, and there is plenty of room for different accounting methods if analysts know which methods are being used [p. 3]. The methods being used should be disclosed because the analyst, not the accountant, is then in the position to know the adjustments to make. [p. 7] All companies should not be made to fit in the same box, but full disclosure is needed so that each analyst can make up his or her own mind [p. 5] The inventory problem is not LIFO versus FIFO but the age of the inventory, whether or not it's obsolete. The depreciation problem is not straight-line versus sum-of-the-years'-digits but lack of confidence in the useful life chosen. Choice of method is less relevant than having the right number of years [p. 4] In many industries, a discussion about FIFO or LIFO or straight-line or sum-of-the-years'-digits never comes up until there is a problem [p. 4]. Until there is an earnings problem, no one asks about the differences between LIFO and FIFO [p. 5].
Alternative view A
Although companies generally should be able to choose between alternative inventory and depreciation methods provided that the method used is disclosed, a rule requiring that all companies use the same accounting method might be useful in some industries or on an industry-by-industry basis. With regard to eliminating alternatives, everybody should not necessarily be doing the same thing because the needs of one industry may be completely different from another, for example, what is good for retail probably isn't good for basic industry, or what the users of a basic industry's financial statements want isn't the same as what users of a financial services industry's financial statements would want. Maybe we need specific accounting practices for an industry and no alternatives [p. 1] There should be more standardization of inventory and depreciation methods but not going so far that everybody has to use the same methods. Standardization should be along industry lines [p. 2]. Different methods are appropriate for different industries [p. 9] Alternative accounting methods are less straightforward beyond inventory accounting. The difference between successful efforts and full costs can be huge and not simple to pin down and can result in sudden huge write-offs [p. 1].
Alternative view B
Only one inventory or depreciation method should be permitted. Need for comparability outweighs whatever conceptual merits particular methods may have [p. 7-9, 13]. Alternative methods make numbers hard to compare, and management should not be able to choose between FIFO and LIFO [p. 15] Only FIFO should be permitted because it better reflects the way inventories are managed and thus better reflects inventory costs and gross profits on sales of invenory, while LIFO can artificially boost profits through decreasing units on hand at year-end [p. 7, 11] Only LIFO should be permitted because it dampens the effects of inflation on gross profits and can be used for tax purposes only if used for financial reporting as well [p. 8, 12] Only straight-line depreciation should be permitted because most companies already use it, and there is little or no reason for a small minority to be different [p. 8-9, 13] Only accelerated depreciation should be permitted because it better reflects the way plant and equipment assets wear out and already is widely used for tax purposes, and its use in financial statements would decrease the differences between reported net income and taxable income [p. 9, 14].
Note: All thirteen pages in this subcategory of the database except the first (some rather general comments from AIMR, Financial Reporting in the 1990's and Beyond, p. 16 and 17) came from the Investors and Creditors Discussion Groups. The meeting materials and postmeeting questionnaires for the investors group meeting 12/9/92 and the creditors group meeting 2/2/93 asked specific questions about the desirability of eliminating either the pooling of interests method or the purchase method of accounting for business combinations. The subject of accounting procedures based on criteria also came up again in discussion of other subjects in the investors group meeting 1/13/93 and the creditors group meeting 3/11/93.
The Leading view and all three Alternative views were expressed during the discussions, but which view or views had wide support and which had only minority support did not become evident until the responses to the postmeeting questionnaires were analyzed. Most comments favoring one method or the other or tolerating both seem to have been based less on enthusiasm for one of the methods than distrust of the other, or distrust of both. Participants generally seemed more aware of, or more perturbed by, the weaknesses and abuses of the purchase method, saying less about the weaknesses and abuses of the pooling of interests method.
Leading view
Companies should continue to be able to structure business
combination transactions in a way that permits use of either the
purchase method or the pooling of interests method if disclosures
about combinations accounted for by the purchase method are expanded
to provide information needed to compare net income before and
after the business combination and the rules for applying both
methods are strengthened. Current accounting principles for acquisitions
basically are working except there is not enough disclosure under
purchase accounting about how the assets are written up or down
at acquisition and about the reserves created at acquisition and
how those reserves are utilized in later periods [p. 5].
For example, inventories purchased are written down and then sold
later with the result that a nonrecurring gain not only is not
disclosed but also is reported as operating income [p. 3, 5]
Acquisitions is an area that the typical analyst looks at with
a great deal of skepticism because it appears that opportunities
are taken to manage the numbers or the process to the company's
benefit. Criticism that the purchase method distorts future reported
results is matched by criticism from the other direction that
the pooling of interests method gives companies the ability to
really buy off multiples, burying the premium that the buyer pays
[p. 8] Purchase accounting is acceptable for very small combination
transactions involving single purpose entities, but a merger of
two very large financial institutions is not a purchase, and the
distortions resulting from purchase accounting are significant.
The merger of operations of that size and scope must retain the
basic concept of historical cost accounting without having to
revalue every asset in today's transaction price. The pooling
is going to be a much more appropriate reflection of that business
combination than the purchase method [p. 7]
Rules for applying the purchase method need to be strengthened
to prevent abuses that allow net income after the business combination
to be inflated by use of overly conservative fair values for assets
acquired, or liabilities assumed, in the combination transaction
[p. 13] Rules for applying the pooling of interests method need
to be strengthened to prevent abuses that allow net income after
the purchase transaction to be inflated by profits on sale of
assets acquired in the combination transaction based on costs
(book values) that ignore the (normally higher) price paid to
acquire the assets in the business combination [p. 13] The two
methods do not fit the same circumstances, and there is no real
problem in having two of them [p. 3]. Each has its
weaknesses, and each has been abused, but they work pretty well
[p. 5].
Alternative view A
Only the pooling of interests method should be permitted. Choice of accounting method makes a difference. Purchase accounting makes analysis difficult going forward because the value of the assets are stepped up or down, affecting reported results for several periods. Lack of comparability is an issue of one accounting method chosen versus another. It would make analysis somewhat easier if one method or the other were applied to all transactions [p. 6-7] The pooling of interests method preserves trends and thus facilitates interperiod comparisons-the assets, liabilities, revenues, expenses, and earnings or net income of the combined company are readily compared with those of the constituent companies before the combination-while the purchase method tends to disrupt trends and make the company after the business combination less readily comparable with the constituent companies before the combination [p. 11].
Alternative view B
Only the purchase method should be permitted. The purchase
method reports the economic reality that most, if not all, business
combinations are acquisitions of one company by another, while
the pooling of interests method ignores the bargaining that led
to the combination transaction, thus opening the way for the acquiring
company to report as profits on sales of the acquired assets significant
amounts that the purchase method more accurately reports as costs
of acquiring the assets [p. 12]. 8(c). Accounting for
leases and other "executory" contractsNote: About one-third
(pages 1-6) of this subcategory of the database consists of excerpts
from AIMR, Financial Reporting in the 1990's and Beyond,
p. 29-34 and 59-62, which recommends capitalization of leases,
a view shared by some members of the investors and creditors groups,
and also of all other "executory" contracts (contracts
awaiting performance by both parties). Two-thirds (pages 6-16)
concerns leases only and came from the Investors and Creditors
Discussion Groups. The subject of leases was raised briefly at
the investors group meeting 10/16/92 and at the creditors group
meeting 12/8/92. The meeting materials and postmeeting questionnaires
for the investors group meeting 12/9/92 and the creditors group
meeting 2/2/93 asked specific questions about the desirability
of accounting for all leases by the same method, eliminating either
the operating lease method or the capital lease method. Leases
came up briefly again in discussion of other subjects in the creditors
group meeting 3/11/93.
Dissatisfaction with present practice seemed to underlie much
of the discussion and many of the views, even of those who wish
to retain both the capital lease and operating lease methods.There
seem to be three Leading views, but the degree of support
for any view is hard to assess from the data. The matter is complicated
by the small number of questionnaires returned by the investors
group and by wide dispersion in answers to the questions about
leases in the questionnaires shown by the following tabulation,
such as the apparent disagreement between the investors and creditors
groups in ranking each of the five views and the apparently contradictory
rankings in the creditors group: at least half ranked each of
three essentially opposing views-(a), (c), and (d)-as 1 (most
preferred) or 2 (next most preferred).
The question asked respondents to rank five views (which are identified by letters here that were not in the questionnaire) with 1 meaning most preferred, 2 meaning next preferred, and so on to 5 meaning least preferred, using each number only once.
MostpreferredLeast
1 2 3 4 5
a. All leases other than month-to-month Creditor 6 1 3 3 1
leases and leases whose terms do not s
extend past the balance sheet date should 1 1 1 1
be capitalized Investor
s
b. All leases should be accounted for as Creditor 1 2 4 5
operating leases s 2 2
Investor
s
c. Some leases should be considered Creditor 4 5 3 1
operating leases, while others should be s 2 1
capitalized. Investor
s
d. The problem with lease accounting lies Creditor 3 7 2
less in whether or not they are s
capitalized and more in the fact that the 1 1 1
following disclosures are missing or Investor
inadequate. s
e. Lease accounting should eliminate Creditor 4 2 6
operating lease alternatives, at least for s
some assets, but the determination should 2 1 1 1
be specified on an industry-by-industry Investor
basis s
A leading view regarding disclosing information about leases is readily identifiable in responses to the questions in the meeting materials or questionnaires.
Leading view
Regardless of their views on whether or not leases should be capitalized, investors, creditors, and their advisors believe that present disclosure of information about leases is inadequate and want cash flows specified by leases and other information to be disclosed. Full disclosure of the obligation under the lease agreement is more meaningful than the way the leases are accounted for on the balance sheet. It is more important to have full disclosure than to account for the lease in a specific way [p. 8] Need separate disclosure of lease obligations by type of asset, for example, real estate, major operating assets, and tangible personal property [p. 13, 15] Need disclosure of maturities of lease obligations by grouping separately leases with short, medium, and long terms [p. 13, 15] Need to distinguish lease obligations by separating obligations representing inescapable future cash payments from obligations which in, say, bankruptcy, would only extend a limited time regardless of the specified lease term [p. 13, 15] Disclosing present value of operating leases could substitute for capitalization [p. 13] As long as an analyst gets the information, he or she can make the adjustments and analyze the effects [p. 12].
Note: Two views regarding capitalizing leases-(a) and (c)-also may be leading views but because they are opposing views, they probably should be considered to be significant alternative views.
Alternative view A
Some leases should be operating leases, while others should
be capitalized. The difference depends principally on
Of the bases suggested by the questionnaire, only lease period
ranked reasonably high, with "strongly agree" on two
and "agree" on seven questionnaires. The other two bases-amount
of lease payments relative to the value of the leased asset (asked
only of investors group) and industry and/or type of asset being
leased-received low ranking from respondents. The following are
other bases suggested by respondents: who bears economic risk
as an indication of true ownership, intention to renew, whether
or not lease substantially uses up economic life of asset leased,
and whether or not ownership transfers at end of lease. In the
airline industry, for example, planes can be leased for one, two,
three years-for a limited period of time. And that is all the
obligation that the airline has, as opposed to a financing lease,
which is a 25-year obligation. To have the same accounting for
both would not do justice to the flexibility that the company
would have from entering into an operating lease [p. 10]
The criteria for distinguishing a capital lease from an operating
lease constitute a form test-a transaction can be structured in
a way to get a certain kind of accounting. Maybe this is not a
question of a choice between alternative methods but that the
form test is not the right form test. The right criteria? A twenty-five-year
lease is pretty clearly a capital lease regardless of what, but
a five-year lease is less clear, right in the middle of gray [p.
10] Companies enter into financial arrangements for more than
just accounting; there are true economic benefits. It's not clear
that the current accounting test finds the right break between
operating and capital leases [p. 11, 12].
Alternative view B
All leases other than month-to-month leases and leases whose terms do not extend past the balance-sheet date should be capitalized. This apparently includes views of users who follow industries such as airlines and retail merchandising and believe that all airplane leases or retail store leases should be capitalized. This also includes views of those who would extend capitalization to all executory contracts with an initial duration of more than one year, including employment agreements and similar contractual arrangements, without weakening standards of revenue recognition. A short-term lease for airplanes should be capitalized. An airline needs airplanes to be a going concern, and payments on airplane leases are like other fixed charges. The way to see the leases' impact on the airline's capital structure is to capitalize them [p. 11] Operating leases need to be adjusted back as if they were capital leases for analytical purposes, for leverage calculations as well as interest cover. Interest cover based on a lease is part of the analysis [p. 9]. Whether or not leases are adjusted depends on the industry. Operating leases are automatically added back and treated as capital leases for retailers and transportation, for example, but not for certain other industries [p. 11] Capitalization of all executory contracts (those awaiting performance by both parties) with an initial term in excess of one year would eliminate many of the problems that plague lease accounting and would place on the balance sheet at least some of the quite real intangible assets-rights to anticipated future cash flows-that do not now appear. Contractual rights are often more significant to service and other nonmanufacturing businesses than are tangible assets but now are not recognized until the anticipated cash is received unless they are acquired in a purchase transaction with an unrelated party [p. 1, 3] Existing rules for accounting for leases are arbitrary and the application often is willfully capricious. The rules have become complicated and excessively detailed because they are designed to foil the machinations that often accompany the classification of lease agreements as operating or capital leases, but instead of introducing comparability and consistency into lease accounting they invite persons having sufficient motivation to study their particulars to be able to write lease contracts that produce desired outcomes [p. 3, 6].
Alternative view C
Leases are a perfect example of things that need not be in the balance sheet but just put in the notes. It would simplify matters greatly if every lease were accounted for as an operating lease coupled with note disclosure of the terms of the lease and the cash flows. The question is the company's real liability because the lessee is responsible for the full value of the rents. The present value of a capitalized lease does not disclose the total amount the lessee is going to have to pay, that is, the total cash outflows [p. 10] The reported liability, either capitalized or disclosed in a note, may not be the true legal liability because of adjustments that can occur, through liquidation or bankruptcy or otherwise [p. 10-11].
Note: The three pages of this subcategory of the database consist of a comment by one analyst on alternative transition procedures permitted by FASB Statement No. 106, Employers' Accounting for Postemployment Benefits Other Than Pensions, which is more pertinent to subcategory 2(c) on comparability, expressions of preferences on certain alternative accounting procedures and expressions of support by a committee of Robert Morris Associates for FASB Statements No. 109, Accounting for Income Taxes, No. 87, Employers' Accounting for Pensions, and No. 106, and expression of support by a committee of the Association for Investment Management and Research for reporting marketable equity securities at market value instead of cost or market, whichever is lower, which is more pertinent to section 4 on value information.