In an earlier piece we recommended an accounting approach that we believe would offer many advantages. Our approach linked a traditional cost based approach with side-by-side fair value financial statements. See pipeline April 2004. Rather than rehash that proposal, we would like to discuss in more depth the problems associated with the current system.

In our view, flawed accounting such as FAS-91 and FAS-133 will lead to sub-optimal behavior. Faced with such twisted rules, firms will seek first to avoid the uncertainty created by the rules. This will lead to techniques like smoothing, threshold levels and hedging to models rather than to markets.

As a natural consequence, management will set up levers to control the accounting results. Initially, management will seek to modify the accounting results to match what they believe are the true economics of the firm. At some point, however, the temptation to manipulate earnings to hide the true economics of the firm may become too great to resist. Management generally believes that they are adding value; accounting results that do not support that outlook are viewed with skepticism. When the rules are not economically based, it becomes extremely difficult for management to distinguish between adjusting accounting results to better reflect the true economics of the firm and manipulating earnings to hide the actual condition of the firm.

Clearly rules that are in place need to be followed, and flaws in the rules are not a justification for earnings manipulation. But these flawed rules should not be allowed to remain a permanent fixture of the accounting landscape. Firms should actively oppose these flawed rules. Complacently accepting FAS-91 and FAS-133 is a disservice to management and investors.