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A lost decade?

Economist Paul Krugman's worries that when the U.S. economy emerges from recession the recovery will be reminiscent of Japan's "lost decade". The Japanese economy stagnated for years following the bursting of its real estate and stock market bubbles in 1989.

Here's my question: Has the U.S. already lived through a "lost decade"?

1) Standard & Poor's points out that the stock market is 39% from Dec. 31, 1999. The last negative decade was the 1930s. Annualized, stocks lost 5.12% so far this decade; in the 1930s they lost 5.26%.

2) The decade's gains in residential real esate are almost gone.

3) I got the stock market numbers from David Henry of BusinessWeek at his blog, Unstructured Finance. He writes: "Some people said we should call this decade the oughts, for the two zeroes. The term didn't catch on. Looking back, it is clear that the real oughts of the 2000s were that we ought not to have paid so much for internet stocks and that we ought not to have paid so much for big houses with granite counter-tops."

4) It has been a lost decade for private sector jobs, too. In a very important post, Mike Mandel of BusinessWeek on his blog calculates notes that between "May 1999 and May 2009, employment in the private sector sector only rose by 1.1%, by far the lowest 10-year increase in the post-depression period." Look at this chart and weep:

5) Real median household income is down for the decade.

My answer: It's has been a lost decade. If Krugman's right, we're actually entering into our second lost decade.

About the author

Chris Farrell is the economics editor of Marketplace Money.
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I am a college professor and apracticing certified public accountant with over 30 years accounting, auditing, and consulting experience in the financial services industry. Working with Dr. Ronald Duska, my fellowship at the Center for Ethics involves research into ethical behaviors in financial reporting and auditing. This research has led us to believe that there are several areas that need to be addressed in the regulatory overhaul, which have not been adequately discussed by the popular press. My insights and recommendations are detailed in this letter.

As regulators and the Congress work toward crafting responses to our nation’s recent financial crisis, we would like to direct your attention to two key issues. Resolving both of these issues will directly affect the ultimate success of any future proposal in preventing or mitigating future market meltdowns. Their resolution also will enhance transparency in the capital markets and contribute to more ethical behavior by companies and their accountants. The first issue deals with problems associated with the recent adoption of “fair value accounting”, while the second involves the professional responsibilities and performance of the auditing profession.

The Value in “Fair Value”

Global accounting standard-setters have been working toward the goal of requiring fair value accounting for more than a decade. So, in one sense, the train has left the station with respect to the ultimate adoption of fair value accounting for financial instruments. Conceptually, the arguments of those favoring fair value accounting are sound and quite appealing. Unquestionably, financial statement users will benefit significantly from information about how a company’s financial assets and liabilities change in value during a reporting period. However, there are some problems. The major problem with fair value accounting is that management has too much flexibility in how it computes and reports these amounts. The “problem values” are those based on Level 2 and Level 3 inputs as discussed in Statement of Financial Accounting Standards No. 157, Fair Value Measurements, which happen to account for most of the assets on financial institution balance sheets. Such guidance effectively allows management to “create” values based on their own assumptions since quoted market prices do not exist. It is particularly troubling that such subjectivity is permitted by the standard setters since their very own conceptual framework (in Concept Statement No. 2, Qualitative Characteristics of Accounting Information), cites reliability as a primary decision-specific quality and verifiability as a necessary ingredient for information to be useful in decision-making. It also is not clear who will enforce the reliability standard associated given the inherent subjectivity of Level 2 and 3 fair values.

The standard-setters have attempted to compensate for the lack of measurement objectivity in their fair value standard by requiring extensive disclosures of how Level 2 and Level 3 asset values are derived. However, they have omitted any requirement that historical cost amounts actually expended for these recorded assets and liabilities be reported together with assumed fair value amounts.

Consequently, we urge you to use your media resources to call attention to the need for including historical cost information for financial instruments in financial statements and accompanying footnotes alongside any fair value data. This supplementary disclosure would highlight any major disparities between cost and fair value, thus potentially mitigating any management incentives to overstate assumed fair values.

It is likely that the investing public will look to a company’s independent auditor to provide some oversight of management’s valuation assumptions. However, we question this third party’s ability to provide effective oversight of the verifiability needed to make fair value information useful. We think it is no coincidence that the move to fair value has occurred simultaneously with attempts by the largest U.S. accounting firms to reduce their legal liabilities for poor quality audits. Unable to secure legislative relief through tort reform, these “Big Four” firms used their significant influence to make generally accepted accounting principles more subjective and judgmental. By doing so, they reduced their exposure to future lawsuits since their audits devolved into reviews of management assumptions surrounding asset and liability valuations.

Additionally, fair values added a complexity to the reporting process beyond the scope of most corporate accounting departments. This likely yielded significant non-audit consulting opportunities for the Big Four firms. Consequently, we now have a very dangerous situation in which the incentives of both the reporting company and its auditor are aligned in favor of fair value reporting. Companies favor it because they can create their own values, and their auditors appreciate it because it is much more difficult to assess audit quality where judgments are involved.

Clearly, the effectiveness of the independent auditor’s report has been diminished by the move to fair value reporting. Therefore, including historical cost data together with fair values is even more critical to provide a benchmark that investors can use to evaluate the reasonableness of management’s valuations.

The Professional Responsibilities of the Auditor

In October of 2008, the Department of the Treasury issued a final report of its Advisory Committee on the Auditing Profession. Many of the report’s recommendations were similar to action calls made during the past thirty years by the Cohen Commission in 1978, the Treadway Commission in 1987, and the O’Malley Panel in 2000. However, the committee made one very important recommendation that specifically recognized problems with today’s public company audits introduced by fair value reporting, which surfaced in our most recent financial crisis. The committee urged the Public Company Accounting Oversight Board (PCAOB) to “consider improvements to the auditor’s standard reporting model,” because of the increased complexity in financial reporting resulting from the growing use of judgments and estimates, including those related to fair value measurements. While we agree completely with this recommendation, we are concerned that this suggestion will not be given the attention it is due for several reasons.

First, the Big Four accounting firms dominate the public company audit market. In the United States during 2006, they audited nearly 98 percent of total public company market capitalization and the same proportion of the largest public companies (those companies with over $1 billion in annual revenues). Moreover, in the same year, they garnered 94 percent of all public company and audit related fees. Clearly, these firms together with their clients have little incentive to move away from their traditional business model, and not surprisingly, will exert significant influence to sustain the “status quo.” Evidence of such pressure can be seen in the Treasury Department Advisory Committee’s unwillingness to even consider whether an “audit only” firm is a more appropriate business model for the profession, or recommend that the Big Four’s audited annual financial statements be made public. It is noteworthy that such respected public servants as Lynn E. Turner, a former Chief Accountant at the Securities and Exchange Commission, and Arthur Levitt, Jr. and Donald T. Nicolaisen, the Committee’s Co-chairs took exception to these inactions.

A second, and more troubling, reason is the fact that public company financial statement errors continue to occur (well over 800 in 2008 alone). These errors, now called restatements, represent accounting mistakes that independent auditors fail to detect in their client companies in such basic areas as recording revenues and expenses, and cash flow reporting. While the PCAOB is supposed to see that public company auditors prepare informative audit reports, the continued high volume of restatements suggests that it has not been effective in policing the Big Four. In fact, between 2005 and 2008, during which over 5400 financial statement restatements occurred, the PCAOB took disciplinary action against auditors in only 20 cases. This relative inaction is probably due to the PCAOB’s approach that reviews the Big Four’s internal operations, rather than focusing on actual instances of auditor error.

Equally disturbing is the PCAOB’s reluctance to release for public view their complete reviews of the Big Four’s audit practices. These reports would allow the investing public to determine the reliability of an independent auditor’s opinion given the audit practices of each of the Big Four.

The staffing of the PCAOB’s board, and senior level division and office leaders also causes concern since the vast majority of the members are attorneys with little or no public accounting or auditing expertise. Clearly, the continued poor quality audits performed by the Big Four, and the inability of the PCAOB to provide effective oversight warrants your attention, particularly with the move to fair value reporting.

Consequently, we urge you to initiate a public debate to encourage the PCAOB to reconsider its approach for overseeing public company auditors, to develop a new public company audit model, to release its full reports on the audit practices of the Big Four, and to require the Big Four to publicly report their audited financial statements.

Conclusion

Many accountants and auditors suggest that, given the complexities of global business, the role played by exotic financial instruments, there is no easy solution to the accounting, and reporting issues brought to light during the recent financial crisis. Unfortunately, given their natural preoccupation with the complexities of individual transactions, they have lost sight of the “forest,” because of the “trees.” Accounting is not a science, nor is it inherently complex. Accounting is about recording measurable assets and liabilities on a company’s books, and auditing is about verifying the existence of these same assets and liabilities. The strength of our proposals regarding fair value accounting and the auditing profession is their simplicity. Their adoption will make a meaningful and lasting contribution to improving financial reporting transparency and ethical business decision-making. Moreover, they are easy to adopt and relatively costless to the investing public and existing regulatory structure.

We respectfully ask that you consider our recommendations, and would very much appreciate the opportunity to discuss these issues with you or your representative further at your convenience. Given the urgency of the problem, we are willing to accommodate our schedules to continue a dialogue with you to create a solution that best serves the public’s interest.

If there are any questions, please direct them to
Anthony H. Catanach Jr., Ph.D., CPA
Maguire Fellow in Applied Ethics
The American College Center for Ethics in Financial Services
Associate Professor and Carnegie Fellow
Villanova School of Business

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