Financial Reporting

Accounting Truth vs. Economic Reality: Dynamic Scoring Brings Neutrality Debate

A controversial Congressional rule calling for dynamic scoring of the economic impact of proposed legislation raises parallels to the debate over the role of economic impact considerations by accounting and audit standard-setters.

Initiated by the newly installed Republican Congress last week, “dynamic scoring” requires the Congressional Budget Office (CBO) to project the economic impact of certain legislative proposals. At issue is the nature of the underlying assumptions about economic behavior arising from, e.g. tax cuts (will people spend more, or less?) and federal investments in infrastructure (will resulting business or job growth produce tax revenue that offsets the cost of the federal spending?). Also at issue is whether members of Congress will try to impose their own biases on the CBO, whose credibility has traditionally relied in large part on its being perceived as neutral.

Under CBO’s previous method of “static scoring,” the incremental revenue or cost of legislative proposals was deemed as its actual dollar amount, without taking into account any additive or offsetting economic effects.

In his Wall Street Journal opinion column, ‘‘Scoring’ Legislation for Growth , Edward P. Lazear, a Hoover Institution Fellow and Stanford Business School professor, supports the change, stating, “The old approach, that ignored effects on economic growth, has been defended as being “neutral,” a way to prevent political pressure from affecting nonpartisan CBO calculations. …The White House has already released a blog post that opposes the change, based on the supposed neutrality of the old approach and arguing that the new rule will introduce bias. But the House, not White House, has it right. Ignoring the macroeconomic impacts of legislation is far from neutral.”

Others, like Jonathan Chait of the New Yorker, criticized the move, as outlined in his column, Why the Republican Congress’s First Act Was to Declare War on Math, .

Rep. John K. Delaney (D-MD) took a middle ground in his Washington Post OpEd, The House Should Keep Dynamic Scoring Honest.

Economic Consequences, Neutrality, and Accounting

There are some interesting parallels between the debate over dynamic scoring of legislation, and the very same debate which takes place in and around accounting standard-setting

In separate speeches delivered at the December, 2014 AICPA Conference on Current SEC and PCAOB Developments, U.S. Securities and Exchange Commission Chief Accountant Jim Schnurr and Financial Accounting Standards Board Chairman Russ Golden defended accounting standard-setting from outside influence or bias.

Emphasizing the need for ,“Open due process, including thoughtfully considering the input and views of those who participate and play a role in our capital markets,” the SEC Chief Accountant warned against, “standard-setting that is focused on other objectives, or on the winners or losers that might result from the provision of neutral decision-useful information.”

He argued that a non-neutral process could deflate investor confidence.

FASB’s Golden pointed out,  “Sometimes,…some people confuse th[e] “cost-benefit” process with the concept of analyzing the “economic impact” of new standards.” The FASB’s job, he explained, “is to provide economically neutral information so investors can make their own decisions.”

“If a standard is asserted to have a negative economic impact,” Golden explained. ”we then must consider if it’s because the standard does not report useful, neutral information—or if it is because it does.”

“However,” he continued, “if we find that the standard neutrally reports the economics of a transaction, it means the standard does work. And if that is the case, then we do not—and should not—change it.”

“If we were to change a standard to portray a more favorable—but false—economic picture,” said Golden, “then accountants would be doing the job of the markets: namely, changing behavior. And I don’t know that’s what you want us to be doing. And I can assure that it’s not our role.”

One could argue that one person’s “favorable – but false – economic picture” is another person’s best case scenario; for what is “economic truth” or “accounting truth”? (I can picture former FASB Chairman Bob Herz in a past speech saying,  “Truth? You Can’t Handle the Truth.” ) The reality is, the possibility of any economic or accounting ‘truth’s’ being self-evident, neutrality or not, has often been viewed as highly questionable, and subject to bias. 

Leases Standard: Case in Point

By way of example, Golden turned to the FASB and IASB’s joint project on Leases, which would move billions if not trillions of dollars (worldwide) of leases that are currently treated as ‘off-balance sheet’ or ‘operating’ leases under existing Generally Accepted Accounting Principles, and put them on-balance sheet as capitalized leases.

“Some have asserted that the leases project will damage the U.S. economy,” said Golden, noting that, among those making that argument, “Their premise is that, by showing a company’s lease obligations on the balance sheet, financial statements will portray companies in a worse light by increasing the company’s reported leverage, and as a result, increase the cost of capital for certain industries, and drives widespread job losses.”

The counterargument, according to Golden, is that, “investors have told us they already are doing back of the envelope-type adjustments to reflect unrecorded lease obligations as being on the balance sheet.” He added, “We’re just giving them a clearer picture of information to use as a starting point for analysis.”

Nevertheless, politicians do sometimes get involved in accounting standard-setting and SEC regulation, either through their formal oversight role (e.g. via the Senate Committee on Banking, Housing and Urban Affairs oversees the SEC and certain other financial regulatory agencies, and the House Financial Services Committee plays a similar role) or by commenting on, or raising questions about, individual rules or standards.

Rep. Brad Sherman (D-CA) and Rep. Peter King (R-NY), stated in their Nov. 9, 2014 WSJ OpEd,  “A Sure-Fire Way to Harm the Economy,” that FASB had not yet responded to calls from Congress for a cost-benefit study – including as relates to the economic impact of-  the proposed leases standard, as well as calls for field testing the proposal.

Christine Klimek, a FASB Spokesperson, provided the following statement to FEI Daily in response to our inquiry on the status of FASB’s consideration of ‘cost-benefit’ of, and calls for study of the ‘economic impact’ of the proposed leases standard.

The FASB welcomes the input of members of Congress on our activities, and has been responsive to their requests for information about our cost-benefit process and how we consider the potential economic impact of our standards. We also have addressed these issues in speeches, newsletters, and other public communication with stakeholders.

The Leases project was added to the FASB’s joint agenda in response to concerns from investors and other financial statement users-as well as the SEC-about the lack of transparency relating to material lease obligations that today are reported off-balance sheet.   The SEC staff in 2005 identified leasing as a form of off-balance sheet accounting that needed to be addressed.

Throughout the stages of a project, the FASB’s due process procedures are specifically designed to generate feedback about whether potential improvements justify the cost of providing them. In developing its proposal on Leases, the Board conducted extensive field work with U.S. stakeholders, including small group meetings with approximately 100 stakeholders to discuss, among other things, the costs and relevance of various lease accounting models under consideration. In addition, during 2012 and 2013, individual Board members and staff participated in more than 50 meetings, panel discussions, webcasts, and in-person seminars with a wide variety of stakeholders. These provided the Board with information about the costs and operationality and the related benefits of the proposals.

Based on what was learned during this process, it appears that lenders already count off-balance sheet lease liabilities when making their credit assessments. In its 2013 outreach with investors and analysts, the FASB found that the majority of those consulted already make adjustments to a lessee’s reported balance sheet to capitalize operating leases when operating  leases are significant to the lessee.  So, while some industries have argued that increased transparency about lease obligations would potentially create a less favorable economic picture of certain companies, this outreach shows that lenders, investors, and analysts already are making these judgments.

Accounting standards are not intended to drive behavior in a particular way; rather, they seek to present financial information so that financial statement users can make informed decisions about how to best deploy their capital.  The purpose of the FASB’s due process is to determine the appropriate representation of the economic phenomena; investors may view the new information favorably or unfavorably and that is the expected consequence of neutral information.

Politics is, of course, a different realm than accounting setting, and the expectations placed on elected officials with respect to influencing or discouraging economic or other activity differs from that of accounting standard-setters.  Historically, and consistent with the recent remarks of Schnurr and Golden, and the governing documents of the FASB, the role of accounting standard-setters is designed to be more one of ‘measuring’ or ‘disclosing’ economic activity, without intending to influence economic activity and/or behavior in a particular direction.

Whether the debate is over ‘dynamic scoring’ in the legislative arena, or ‘dynamic provisioning’ in the accounting standard-setting arena (a concept debated by the FASB-IASB’s joint Financial  Crisis Advisory Group or FCAG, formed in the aftermath of the economic downturn, amid questions surrounding whether accounting standards could have contributed to procyclicality or countercyclical economic behaviors) the questions surrounding economic impact and its cousin, “cost-benefit” are always interesting to observe.