Moonstay Corporation Case Instructions

Mark-to-market Accounting

This thought-provoking and immensely readable collection of articles, speeches and letters by Walter Schuetze, one of the world’s most distinguished accounting practitioners, is a work for our time.

In the wake of the largest surprise corporate failures and retrospective financial restatements in corporate history, Walter Schuetze and Peter Wolnizer (as editor) turn their attention to what they call the syndrome of “Enronitis.”

They contend that the unheralded collapse of companies such as Enron and WorldCom in the USA, and HIH Insurance in Australia, shows the failure of conventional accounting and auditing practices to provide high-quality financial information for investors as intended by law. It is little wonder, therefore, that public confidence in financial reporting, auditing and corporate regulation is at an all-time low.

This book argues that it is time to base financial reports on up-to-date prices — current selling prices for assets and current settlement prices for liabilities— and to disclose the details of those who provide the market price data.

In this strongly practical case for mark-to-market accounting, the authors demonstrate how such a regime would put a stop to earnings management and establish a firm financial foundation for corporate governance and independent auditing. Providing nothing less than “true north” in financial reporting.

This book will be essential reading for advanced students and academics in the field of accounting.

Walter P.Schuetze is a certified public accountant. He was chief accountant to the Securities and Exchange Commission (1992–5) and chief accountant of the commission’s Enforcement Division (1997–2000).

Peter W.Wolnizer is dean of the Faculty of Economics and Business and a professor of accounting in the University of Sydney. He is author of Auditing as Independent Authentication and has written extensively on financial accounting and auditing.

Routledge New Works in Accounting History Series editors: Richard Brief, Leonard N.Stern School of Business, New York University; Garry Carnegie, Deakin University, Australia; John Richard Edwards, Cardiff Business School, UK; Richard Macve, London School of Economics, UK

The Institute of Accounts Stephen E.Loeb and Paul J.Miranti

Professionalism and Accounting Rules Brian P.West

Accounting Theory Essays by Carl Thomas Devine Edited by Harvey Hendrickson and Paul Williams

Mark-to-market Accounting “True north” in financial reporting Walter P.Schuetze, edited by Peter W.Wolnizer

Mark-to-market Accounting

“True north” in financial reporting

Walter P.Schuetze,

edited by Peter W.Wolnizer

LONDON AND NEW YORK

First published 2004 by Routledge

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Simultaneously published in the USA and Canada by Routledge

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Routledge is an imprint of the Taylor & Francis Group

This edition published in the Taylor & Francis e-Library, 2005.

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© 2004 Walter P.Schuetze and Peter W.Wolnizer

All rights reserved. No part of this book may be reprinted or reproduced or utilized in any form or by any electronic,

mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information

storage or retrieval system, without permission in writing from the publishers.

British Library Cataloguing in Publication Data A catalogue record for this book is available from the

British Library

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ISBN 0-203-63399-7 Master e-book ISBN

ISBN 0-203-63739-9 (Adobe eReader Format) ISBN 0-415-29955-1 (Print Edition)

To our wives Jean and Gaye

Contents

Notes on author and editor ix

Foreword xi

Letter from Fred Talton xiii

Acknowledgments xiv

1 Walter P.Schuetze: accounting reformer PETER W.WOLNIZER

1

2 Autobiography WALTER P.SCHUETZE

20

PART I Accounting for assets and liabilities 32

3 Schuetze on accounting for assets and liabilities PETER W.WOLNIZER

33

4 Keep it simple 46

5 What is an asset? 52

6 What are assets and liabilities? Where is true north? (Accounting that my sister would understand)

59

7 New chief accountant’s wish list 85

8 Relevance and credibility in financial accounting and reporting

90

9 Why are we all here anyway? 99

10 Accounting for restructurings 103

11 Enforcement issues, and is the cost of purchased goodwill an asset?

110

12 Cookie jar reserves 115

13 Financial instruments 120

14 Accounting for transfers of receivables (by Tom, Dick, and Harry)

124

15 Discount rate re cash outflows for nuclear decommissioning and environmental remediation

132

16 Discount rate for pension liabilities 135

17 Exposure Draft E55: Impairment of Assets 137

18 Exposure Draft E59: Provisions, Contingent Liabilities, and Contingent Assets

139

19 Exposure Drafts E60: Intangible Assets, and E61: Business Combinations

142

20 Business combinations and intangible assets 147

21 Accounting for the impairment or disposal of long-lived assets and for obligations associated with disposal activities

154

22 Business combinations and intangible assets: accounting for goodwill

157

23 The FASB and accounting for goodwill 161

24 Accounting for financial instruments with characteristics of liabilities, equity, or both

165

25 Accounting for stock options issued to employees 168

26 Proposed interpretation: guarantor’s accounting and disclosure requirements for guarantees, including indirect guarantees of indebtedness of others

174

27 Your proposed interpretation: consolidation of certain special-purpose entities

175

PART II The implications of accounting practices for auditing 178

28 Schuetze on the implications of accounting practices for auditing PETER W.WOLNIZER

179

29 Disclosure and the impairment question 189

30 The liability crisis in the USA and its impact on accounting 196

31 Reporting by independent auditors on internal controls 202

32 A mountain or a molehill? 209

vii

33 Comments on certain aspects of the special report by the AICPA’s Public Oversight Board of 5 March 1993

218

34 Enforcement issues: good news, bad news, Brillo pads, Miracle-Gro, and Roundup

226

PART III Accounting standard setting and regulation 234

35 Schuetze on accounting standard setting and regulation PETER W.WOLNIZER

235

36 The setting of international accounting standards 247

37 What is the future of mutual recognition of financial statements, and is comparability really necessary? Information is king

251

38 A note about private-sector standard setting 256

39 Take me out to the ball game 260

40 Financial accounting and reporting in our worldwide economy

266

41 SEC accounting update 274

42 A review of the FASB’s accomplishments since its inception in 1973

279

43 Current developments at the SEC 284

44 A memo to national and international accounting and auditing standard setters and securities regulators (a Christmas pony)

291

45 Hearing: “Accounting and Investor Protection Issues Raised by Enron and Other Public Companies: Oversight of the Accounting Profession, Audit Quality and Independence, and Formulation of Accounting Principles”

303

46 Watching a game of three-card monte on Times Square 310

47 IASC due process 320

Index 324

viii

Notes on author and editor

Walter P.Schuetze was chief accountant to the Securities and Exchange Commission (SEC) of the United States of America from January 1992 through March 1995, when he retired. He was appointed chief accountant of the SEC’s Enforcement Division in November 1997 and served through mid-February 2000, when he retired again. He was a consultant to the Enforcement Division from March 2000 through March 2002 on matters involving accounting and auditing.

Mr Schuetze is currently a consultant in various litigations as an expert in accounting and auditing. He is also an executive in residence in the College of Business at the University of Texas in San Antonio and a member of the boards of directors and chairman of the audit committees of Computer Associates International Inc. and TransMontaigne Inc.

He was a charter member of the Financial Accounting Standards Board, serving as a member from April 1973 through mid-1976. He was a member then chairman of the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants. He was a member of the Steering Committee of the International Accounting Standards Committee dealing with intangible assets, business combinations, and impairment of assets. He has delivered occasional lectures on accounting at the business schools of St Mary’s University in San Antonio, the University of Texas in San Antonio and the University of Southern California in Los Angeles.

Walter Schuetze began his career in accounting in 1957 with the public accounting firm of Eaton & Huddle in San Antonio, which merged with Peat, Marwick, Mitchell & Co. (now KPMG LLP) in 1958. He was a partner in KPMG from 1965 to 1973, when he was appointed to the Financial Accounting Standards Board, and from 1976 to 1992, when he was appointed to the position of chief accountant to the Securities and Exchange Commission.

He served in the US Air Force from 1951 to 1955. He received a Bachelor of Business Administration degree, with honors, from the University of Texas at

Austin in 1957. He is a certified public accountant, a member of the American Accounting Association and the American Institute of Certified Public Accountants, and a member of the Beta Alpha Psi and Beta Gamma Sigma honorary societies. He was born on 2 August 1932.

February 2003 Peter Wolnizer is dean of the Faculty of Economics and Business and a professor

of accounting in the University of Sydney, Australia. Previously, he held the foundation chair of accounting and finance in Deakin University (1989–99), where he served as foundation dean of the Faculty of Business and Law (1991–99). Prior to those appointments, he held lecturing positions in the University of New South Wales (1973–5) and the University of Sydney (1976–87), and a readership in the University of Tasmania (1987–8). Before entering academic life, he worked for six years in industry, commerce and the accounting profession.

Professor Wolnizer has also been appointed to visiting professorial or research fellowship positions by the Universities of Canterbury, Glasgow, Kansas, Pittsburgh and Utah—most recently as the James Cusator Wards Visiting Professor in the University of Glasgow (1993 and 1998), Visiting Professor at the Czech Management Center in Prague (1995), and Visiting Erskine Fellow in the University of Canterbury (1998).

He is chairman of the Board Education Committee and Professional Education Board of CPA Australia, the Asia-Pacific member of the Education Policy Committee of the International Association of Financial Executives Institutes, and a member of the Research and Publications Committee of the Committee for Economic Development of Australia (CEDA). He served as a member of the Council of the Scots College (Sydney) from 1999 to 2002, a member of the Council of Scotch College (Melbourne) from 1998 to 2001, and a member of Australia’s Corporations and Securities Panel from 1995 to 1998.

Peter Wolnizer has a Bachelor of Economics degree from the University of Tasmania, and the degrees of Master of Economics and Doctor of Philosophy from the University of Sydney He is a Fellow of both CPA Australia and the Institute of Chartered Accountants in Australia. His fields of expertise are financial accounting, auditing, and corporate governance. He is the author of Auditing as Independent Authentication (Sydney University Press, 1987) and editor of five books. His articles have been widely published in scholarly and professional journals; several having been reproduced in anthologies, journals and textbooks published in the USA, UK and Australia.

February 2003

x

Foreword

Were an anthropologist from Mars to descend upon our financial world, observing companies presenting their financial positions, what an Orwellian experience it would be. The language of statutory obligation demands that they give a true and fair view. Yet there is no explicit obligation for that truth and fairness to be grounded upon the actuality of current market selling prices for assets and their reciprocals for liabilities. Our Martian would, if of historical bent, identify precisely when the rot set in: 1844, when the Joint Stock Companies Act was passed in the United Kingdom. For that research, we are indebted to the late Professor Ray Chambers and his former pupil, now professor and dean, Peter Wolnizer, at the University of Sydney’s Faculty of Economics and Business. He is the thoughtful and discerning editor of this collection, adding important linking essays of his own.

It is rare to find an intellectual lineage that starts in the 1950s with an Australian progenitor, Ray Chambers, who pioneered with Walter Schuetze many of these seminal ideas. They proceeded on largely parallel tracks, like Leibniz and Newton devising calculus. It must be rarer still to find a disciple, again Australian, who collaborates with Professor Chambers, then engages in an intense and deeply reflective exchange with Walter Schuetze in the United States. Those connections are the intellectual underpinning of Professor Wolnizer’s discerning editorial work, in which he brings to the Australian context a theme of international importance. That theme is one of outstanding simplicity, intuitively convincing, yet nowhere adopted as mandatory policy for corporate reporting. I refer to “mark-to-market accounting,” so far the preserve only of those parts of a business that invest in marketable securities.

That Walter Schuetze early in his career studied Russian has, for me, a literary resonance. Tolstoy wrote a memorable short story about an archetypal character of Russian literature, the holy simpleton. The story was entitled, as I recall it, “The Shoemaker.” This was a character of profound simplicity. He is not to be confused with Chauncey Gardner, the Peter Sellers character in the film Being There, a character

of profound inanity. Tolstoy’s shoemaker gently disarms untruth. He does so by unselfconscious intuition about what is right, expressed in simple terms; in the supposedly “real” world, an ingénue. Walter Schuetze is in some respects of that character, with his Texan directness, collo-quial and jargon-free. For his paradigm is “accounting my sister would understand.” He is also a person whose personal character was severely tested when a partner at KPMG. When asked to give auditing dispensation to the thrifts and saving associations, with their shonky pseudo- partnerships masquerading as loans, he, with the backing of his firm and at real cost, simply refused. If only the same had been done with Enron’s audit.

But what impact has Walter Schuetze made in Australia? Some months after a memorable dinner in the Great Hall at the University of Sydney on 27 November 2001, at which Walter Schuetze gave the R.J.Chambers Memorial Research Lecture, I was approached by a critic: “this was a very unfortunate affair, did you not see how uncomfortable some of our invited guests were, especially some of the accountants, at Schuetze’s radical views?” (I add that most of the accountants there were full of praise.) For those that would listen, he was telling us that in the world of corporate emperors many were overdressed; but beneath the Zegna suits they had no clothes at all.

The critic’s observation, made after Enron had emerged, allowed me the perfect riposte. It was that Schuetze had shown extraordinary prescience in his appreciation of what was to come. Those accountants who were skeptical would have done well to heed his words rather than stone the prophet.

This book is a tribute both to its editor and to those who inspired it, but most especially to Walter Schuetze. It deserves a wide and discerning audience who take its message seriously. For what is at stake is nothing less than a fundamental underpinning of our capitalist system. It is a call, yet to be heeded, for accounts we can understand, who tell it like it is.

The Honorable Justice G.F.K.Santow, Chancellor, University of Sydney, 31 January 2003

xii

Letter from Fred Talton

The following note, in handwritten form, was received by Walter P.Schuetze in June 2002 from Fred W.Talton, who was a partner in PMM&Co. in the Raleigh, North Carolina, office in the 1980s at a time when Mr Schuetze was a partner in PMM&Co.’s Department of Professional Practice.

2728 Branch Road Raleigh, North Carolina 27610

28 June 2002

Dear Walter, As a CPA who retired from PMM&Co. in 1987, I have reflected many times on

various accounting and audit situations that I encountered during my career. In seeking help in these matters from the Department of Professional Practice, you were quite often the person that I called on for help. The responses that I received from you were always well thought out and reasonable, though not always what our clients wanted to hear. During that period, I felt that, in working with you, I was always working with the ultimate professional.

Over the years, and especially in the most recent years, I have often thought that all of our audit partners owe you a real debt of gratitude for being such a professional in dealing with client matters. I believe some of the thoughtful, reasonable positions you took have saved the firm and its partners many millions of dollars and great embarrassment

Please allow me to express my own appreciation and respect for your service.

Sincerely, Fred W.Talton

Acknowledgments

For his scholarly advice, encouragement and support for this work, we express our sincerest appreciation to Professor Richard P.Brief of the Leonard N.Stern School of Business in New York University, an eminent scholar of the history and development of accounting thought. And we are honored by, and deeply grateful to the Honorable Justice Kim Santow, a Judge in the Court of Appeal, Supreme Court of New South Wales, and Chancellor of the University of Sydney, for writing the foreword.

We acknowledge, with gratitude, the permissions given by publishers to reproduce in this volume the eight previously published articles and lectures by Walter P.Schuetze; and the permissions given by Sir Bryan Carsberg and Mr Fred Talton to reproduce their letters to Walter Schuetze.

Ron Ringer provided invaluable technical and editorial assistance in transforming dozens of differently formatted documents into the uniform style prescribed by Routledge, for reading and checking the entire manuscript, and for coordinating the project. Sincere thanks are also extended to Carl Harrison Ford, Walter P.Schuetze and Dr Robert R.Sterling for reading and providing constructive comments on the editorial essays.

We are indebted to the editorial staff of Routledge (London) for their very helpful advice and ready cooperation in respect of all publishing-related matters.

For the provision of a research grant to support this work, we express our sincere appreciation to the Accounting Foundation within the University of Sydney.

Permissions

The authors gratefully acknowledge permission to reproduce the following articles in full:

“Keep it simple,” reproduced by kind permission of Accounting Horizons American Accounting Association, Vol. 5, No. 2, June 1991, pp. 113–17.

“What is an asset?” reproduced by kind permission of Accounting Horizons, American Accounting Association, Vol. 7, No. 3, September 1993, pp. 66–70.

“Disclosure and the impairment question,” © 1987 from The Journal of Accountancy by the American Institute of Certified Public Accountants. Opinions of the authors are their own and do not necessarily reflect policies of the AICPA. Reprinted with permission.

“The liability crisis in the US and its impact on accounting,” reproduced by kind permission of Accounting Horizons, American Accounting Association, Vol. 7, No. 2, June 1993, pp. 88–91.

“A memo to national and international accounting and auditing standard setters and securities regulators (a Christmas pony),” 2001 R.J.Chambers Memorial Research Lecture in the Great Hall, the University of Sydney, Australia, 27 November 2001, reproduced by kind permission of the Accounting Foundation within the University of Sydney.

“Reporting by independent auditors on internal controls,” reproduced by kind permission of The CPA Journal, October 1993.

“A mountain or a molehill?” reproduced by kind permission of Accounting Horizons, American Accounting Association, Vol. 8, No. 1, March 1994, pp. 69–75.

“What are assets and liabilities? Where is true north? (Accounting that my sister would understand),” Abacus: A Journal of Accounting, Finance and Business Studies, Vol. 37, No. 1, February 2001, pp. 1–25, Blackwell.

Speeches by Walter Schuetze in his capacity as a member of staff of the SEC are in the public domain. Letters written by Walter Schuetze are copyright to the author.

xv

1 Walter P.Schuetze Accounting reformer

Peter W.Wolnizer

This is a unique and timely work. While pertinent to the era of the modern corporation, it is especially a work for such a time as this. For corporate financial reporting and auditing are again sharply under the spotlight of governments and regulators around the world—this time, in the wake of the most significant unexpected corporate failures and surprise retrospective financial restatements in corporate history, a syndrome we call “Enronitis.”

The recent and unheralded failures of Enron and WorldCom in the USA, and of HIH Insurance, One.Tel, and Ansett in Australia—and the unexpected retrospective restatements by a large number of public companies in the USA1— have occurred when, by law, investors, creditors, and others are to be informed truly and fairly of the up-to-date financial position and performance of the reporting enterprises. But, again, as we have seen repeatedly in the past, the financial instrumentation system by which investors and creditors are to be so informed (financial accounting and reporting), and the quality control system by which the reliability of that financial instrumentation system is to be assured (auditing), have failed to provide the reliable and high-quality financial signals and informative safeguards for the investing public intended by the Corporations and Securities Laws. The syndrome of Enronitis is not new. In the USA, for example, there were the unexpected collapses of Equity Funding and Penn Central in the 1970s, and the savings and loan fiascos of the 1980s and 1990s. In the UK, there was Pergamon in the 1970s, and Maxwell Corporation and BCCI in the 1990s. In Australia, there were Reid Murray, Latec Investments, Stanhill, and H.G.Palmer in the 1950s and 1960s; Minsec, Cambridge Credit, Mainline and Associated Securities Ltd in the 1970s; and Bond Corporation, Rothwells, Adsteam, Westmex, and Qintex in the 1990s.2 And those are just a few of the notable corporate catastrophes.

This book addresses the prevalent and recurrent accounting and auditing problems highlighted again in the most recent corporate financial debacles. It contains an autobiographical essay and a collection of seven articles, eighteen speeches and

addresses, and sixteen letters written by an eminent accounting practitioner, standard setter and corporate regulator—Walter P.Schuetze. Though addressed to diverse, but expert, audiences about specialist and often technically complex matters, their distinctive, plain English style makes them intelligible to all who are interested in financial accounting and reporting, and their function in informing financial decision making and capital markets.

Without drawing on the ideas and work of others, Schuetze sets forth, in a compelling and highly readable fashion, his ideas about financial accounting and reporting, auditing, accounting standard setting and corporate regulation. The work is novel in many respects, most of all perhaps because those ideas evolved throughout a career in accounting practice spanning more than forty years— many of them spent at the zenith of the accounting profession (as a partner in KPMG), accounting standard setting (as a charter member of the Financial Accounting Standards Board, a member of the Financial Accounting Standards Advisory Council and chairman of the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants), and securities regulation (as chief accountant to the Securities and Exchange Commission in the USA and chief accountant of the Enforcement Division of the Securities and Exchange Commission). Schuetze’s ideas fundamentally challenge the conventional accounting and auditing wisdom and advocate deep change and major reform. They offer a solution to the widely recognized problem of earnings management, and a cure for Enronitis.

The observations, ideas and arguments contained in this collection are born of personal experience, an encyclopedic knowledge of accounting and auditing standards and practices, an analytically incisive mind and a razor-sharp intellect. They are informed by direct personal observation of what styles of accounting do and do not work and by a professional passion to improve the quality of financial accounting and reporting in the interests of better informing capital markets and the financial decisions of investors and creditors. They are founded on an unshakable commitment to the highest ideals and standards of professional ethics and personal integrity. Walter Schuetze is an independently minded and thoughtful man who is given to measured and informed judgment—a consummate professional, a true reformer.

Schuetze’s ideas and proposals for accounting and auditing reform are no recitation of the wisdom of others. His writings contain remarkably few citations or references. They contain no appeals to authority or support in the academic and professional literature. Although he is well and widely read, his ideas are shaped by intuition, common sense, observation and experience. Walter Schuetze’s distinguished career, professional standing, expertise and strength of character speak loudly.

His autobiographical essay is highly informative and a delight to read. It reveals how a boy reared on a farm in south-central Texas was shaped by the education he received at two small schools, and of the tremendous impact and legacy left to him by a few highly dedicated