Installment # 44

Two thoughts frame my working years as I reflect back:  Early in my career I listened to a motivational speaker, evidently a few years older than me, describe his excitement as a boy standing in front of the candy displays at the candy store with a penny in each hand, trying to decide what he wanted.  I only remember the long, narrow strips of paper with colorful dots of candy attached that we could still get for a penny in my day.  They were called “Dots,” in fact.  The speaker described the wonder and excitement and anticipation of having all these wonderful choices in front of him, clutching in his hands the two pennies that represented his right to choose and enjoy.  He then compared this to our lives, where the two pennies represent Time and Talent.  We were standing at the thresholds of our careers, with time and talent on our sides.  The choices we made now would determine the paths of our lives in many ways.

At the other end of my working years is something that Donald said to me: “Tommy, you will know when you are done.”   I would tell him that I didn’t know whether I was retired, semi-retired, or just tired.  Was I trying to find full-time work?  Was I content with the part-time work I had?  Was I going through a temporary lull in my drive and ambition, or was I ready for full-time retirement?  Don’s words came back to me many times: “You will know when you’re done.”  That time did come, sometime in mid-2013.  I’m done.  Thanks, Don.

When I started in public accounting I learned that Berkeley was known for its theoretical approach to teaching accounting.  A standing joke was that Berkeley was so theoretical that its graduates didn’t even know how to spell SEC.  I must admit that one of my favorite quotes came from a Berkeley professor who said, “The concept of periodic net income would be indefensible, were it not indispensable.”  He explained that if you understood business and economics correctly you would see that the idea of taking a short period of time, like a quarter of a year, and trying to quantify the net results of all the economic activity of a corporation was futile, if not ridiculous.  It is also disruptive.  He likened it to trying to grow, say, a carrot that requires a full growing season, and pulling it out of the ground every few days to check on its progress.  It not only doesn’t tell you much, but it is really harmful to the carrot.

With my penchant for being literal, I learned in college, and it stuck with me, that an income statement reflecting a loss is called a statement of operations, not an income statement, so as not to be misleading or contradictory.  In practice they call it the “P&L”, which stands for Profit and Loss.  Right away I objected and pointed out that it must be either a Profit statement or a Loss statement; it can’t be both.  Shouldn’t we refer to it as the profit OR loss statement?  That suggestion from the new guy was not well received, as I recall.  It’s just that “profit and loss” sounds like “income and expense” or “receipts and disbursements”, either of which has meaning.  But “profit and loss” sounds like a statement that is going to list all of the items of ‘profit’ and then all of the items of ‘loss’, and come down to a net number that will either be a net profit or a net loss.  That is not the way it works.

My reaction to the accounting education I was receiving while in college was that it was challenging and interesting, sort of like doing crossword puzzles.  And auditing at Arthur Young was similar.  It is mental gymnastics that you can get good at within the first six months to a year.  I remember being taught that, at least in the 1970s, you could be sued for being negligent, but not for having poor judgment.  If the client’s financial statements had to be restated after they were issued with a “clean” audit opinion, and it was felt that you would have caught the error if you had performed certain audit procedures, you were on safe ground if you had documented that you had considered performing the audit procedures and why you felt they were not necessary.  But if you simply didn’t do something – if it appeared that you neglected to even consider something that later proved to cause a misstatement – then you could be in trouble.  Thus, the game was not only to document the audit steps taken and the results thereof, but to document your thinking regarding audit steps not taken: show that you at least thought about the issue, and used poor judgment – that you were not neglectful.  We were under budget and time constraints; we couldn’t do everything.  It really was a game of mental gymnastics.

So my cynicism extended not only to accounting and financial reporting, but to the audit process, as well.  I was in public accounting from 1973 to 1980, but in the corporate accounting field and interfacing with external auditors essentially all my career.  I can report that it is not possible to be passionate about something that you are cynical about.  But you can make a living at it.  By the time I left Berkeley I understood that net income was a rather meaningless number.  Once I had the privilege of auditing a client’s calculation, I realized that earnings per share (EPS), one of the most vital bits of information to investors and analysts, is really just one meaningless number divided by another meaningless number.  Actually, there are two: primary earnings per share and fully diluted earnings per share.  The denominator starts with the calculation of the weighted average number of shares of stock outstanding during the same period as the earnings (usually the Company’s fiscal quarter or year-to-date) and then makes some assumptions regarding stock options and warrants, treasury shares and convertible preferred shares, etc, to arrive at fully diluted “as if” a number of events had taken place that really hadn’t.

To go further afield, investors and analysts publish estimates of what future EPS will be, which affects the current market price of the stock; and the current price of the stock enters into some of the “as if” assumptions in the first place.  It gets worse: in the high technology industries, stock options are used to attract and retain the best engineering talent, which in turn is critical to the future of any company in the industry.  And the value of stock options is directly related to the market price of the stock versus the option price. If the market price of a company’s stock starts to slide, the options are worth little or nothing, and the engineering talent starts walking out the door, harming the company’s future even more.  It is a little like the story of the old watchman in days of yore who was responsible for ringing the bell in the tower each hour on the hour to denote the time.  He would pass a watch shop on his way to the tower, and set the tower clock based on what the large watch in the store window read.  When he mentioned this, the store owner said, “Oh, no.  I set that watch based on your ringing of the bell!”

I think the final straw came for me when the accounting profession decided that stock options needed to be valued, and the estimated value (cost to the company) spread over the related period of years that the Company expected to receive the benefit of these costs.  No sane layman could listen to the (necessarily) convoluted machinations involved and believe that any resulting calculations could be used for the purpose of recognizing costs in the accounting records.  It is ludicrous. 

The idea is: If the Company grants you an option to buy, say, 10,000 shares of company stock at the market price on the date of grant, say $10 per share, at any time in the future that you like, how much is that worth at the date of grant? (By the way, the usual terms call for vesting over time – for example 20% per year {or 2,000 shares per year in the above scenario} over the next 5 years).  That “worth” will be amortized over those 5 years (the period of service) into the Company’s reported expenses.  A theoretical justification is that the Company would have had to offer you a larger salary if it had not granted you the stock options, so those options must be worth something.  In actuality, nearly all public companies in the same industry follow similar hiring practices, offering very predictable combinations of starting salary and options at each level.  There is no choice and no discussion with the new employee regarding what the starting salary would be in the absence of a grant of stock options.

First of all, getting back to the worth of the options on the date of grant, if the market price of the stock goes down instead of up (as often happens), the options are not worth anything.  The approach to placing a value on the options considers only the upside potential, applying a volatility factor based either on the past volatility of the stock in the public marketplace, or on an assumption.  My cynical mind considers: If I offer to grant you the options outlined above, how much would you pay me for them?  The answer will vary all over the board, depending on the existing wealth of the individual and his appetite for risk.  Many incoming employees would likely say, “Zero.  I would like to have them for free, but I would not pay you for them…they may never be worth anything!”  The Accounting profession really lost me when they abandoned the concept of “fixed or determinable” in favor of this ludicrous attempt to record some cost – any cost – over the years in which the options vest, which in turn is taken to represent the period of the employee’s service to the Company.

It made a lot more sense to me when the practice was to record costs and expenses when they were determinable or reasonably estimable, but only disclose in footnotes those situations that could not be determined or estimated with any meaningful precision.  For example, if the Company is being sued for $10 million, but it is too early to tell whether the case will be upheld, dismissed or settled for something way less than $10 million, you don’t estimate or take an average of possible outcomes, or take a worst case scenario, and record an expense in the books.  You disclose the situation, usually including whether the Company feels the suit is frivolous or intends to defend itself vigorously, or what.  But for some reason, the Accounting profession feels they must come up with a value to place on stock options, spurious as that may be, and recognize the related expense in the Company’s books.  The profession crossed the threshold from fact-based to fiction-based accounting. Prior to that turn of events, which took place in the early 2000s, my pet peeve was accounting for income taxes.  Honestly, you could have six “experts” come up with six different answers.  And the required disclosures were mind-numbing.  Only another tax accountant could possibly follow and understand it.

Periodic net income is the result of a combination of numerous assumptions, estimates, judgments and allocations made by management in the process of closing the books.  The accounting rules attempt to narrow the range of differences inherent in the process, but leave significant leeway nonetheless.  The rules simply cannot anticipate every possible set of facts and circumstances and related nuances.  They use terms such as “more likely than not,” “fixed or determinable,” “reasonably likely,” “not misleading,” “impaired,” and the like to guide management and the auditors in arriving at the proper accounting treatment.  Typically management builds its case and makes a decision, and the auditors make a show of “challenging” the decision, but usually end up agreeing, under the rationale that management is closer to the situation and is in the best position to make the call.

Back during my theoretical accounting education at Berkeley, I recall a professor telling us to always try to identify “the client of the system.”  He explained that real understanding comes from observing a process in action and seeing through the facades to the real beneficiaries of the process.  The professor may have been a little cynical when he asked questions like: Who are the real beneficiaries (clients) of the banking system, the medical system, the news media establishment, etc?  Is it really the customer, the patient, the public, etc, or are these systems really functioning to serve the bankers, the doctors, the pharmaceutical companies, the news conglomerates, etc?  During my 2 ½ years stationed in Germany we had 3 annual visits from the Inspector General (IG).  Each time our leaders panicked and had us scurrying around like crazy people preparing for the inspection.  By the time the IG arrived everything and everybody was spotless and in its right place.  I would ask: “What’s wrong with the way we always live?  If it’s not good enough, why don’t we change it permanently?”  The answer was something along the lines of:  “We want to show proper respect for the IG.  He knows that we don’t always live this way.” That amazed me: He goes around to the military bases to see that once per year the units make their places look way better and way different than normal; knowing that is the case.  What is the point of all this?  Who is the client of this system?

This same professor brought to my attention for the first time, the critical difference between association, on the one hand and cause-and-effect, on the other.  This was in the early ‘70s, during Watergate and the impeachment of Richard Nixon, just after the tragic campus riots over the Vietnam War, and only a few years after Mario Savio and the free speech movement took place on that very campus.  His example was the campus riots, where dozens of news people would show up to record and report on the events as they unfolded.  Some observers had suggested that it was the ever-present news people who were instigating and starting the riots in order to create sensational news to report.  The professor said, first of all that he was there – had first-hand knowledge – and that these suggestions were wrong.  Just because the news media was on hand, it did not mean that they were causing the events.  He also reminded us to ask ourselves, “Who is the client of the system?”  In this case was it the news people who were being served, or the rioters or the public’s right to know or what?

The accounting, auditing and reporting systems serve management, the accountants, the underwriters, the brokerage houses, the auditors, the boards of directors…everyone except the readers of the financial statements.  But I went along with the gag, so to speak, because it was a good way to make a living and it was intellectually stimulating.  But I could never get emotionally involved.  During the relatively short time I was in public accounting (1973 – 1980), I found that accounting and auditing were fairly stable, slow-changing bodies of knowledge that one could master and keep up  with, whereas taxation and tax accounting were ever-changing.  You could “dabble in” accounting, but you had to practice tax.  The literature and the laws surrounding taxation, tax accounting and tax reporting were changing all the time.  You could never feel that you had mastered it. 

During the last 10-15 years of my career, however, it became the same way with accounting, and the only way to keep up was to work for an accounting firm, with its continuing professional education and continual exposure to new situations and new rules.  Now you have to practice accounting.  It is not a body of knowledge anymore, but a legalistic art form that serves primarily itself.