The Gap in the Perception of the GAAP

As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) THE GAP IN THE PERCEPTION OF THE GAAP ISRAEL KLEIN ABSTRACT Financial accounting is the language of the business world and generally accepted accounting principles (GAAP) comprise its terminology. The dictionary-like use of GAAP in business discourse conveys a conception of accounting standards as definitional rules, i.e., as rules that merely provide consensual definitions for financial discourse without affecting the content of the discourse. As such, GAAP is believed to be neutral and bias-free and consequently, promulgation of accounting standards and the content of the GAAP have not attracted much legal attention. This article challenges the prevailing legal indifference towards the GAAP and those promulgating it. By revealing GAAP's effects on corporate behavior and on the function of many social, political and financial systems that utilize accounting parameters, this article discusses the substantive power private parties gain through the promulgation of accounting standards and how these standards imply a biased agenda that prefers the investor perspective over other contrary perspectives, thereby establishing a skewed financial perception of reality, such that subordinates the social order entirely to investors’ objectives. While reviewing how the GAAP is perceived by the court, this article further argues that the existing legal perception of accounting standards as neutral definitional rules has yielded court rulings that relieved accounting standards promulgators from professional duties and has prevented judicial review of the standards themselves, leaving the GAAP and its promulgators practically immune to legal scrutiny. Attention is then drawn to a possible solution presented by a recent SEC proposal to allow domestic issuers to disclose supplemental IFRS-based financial results in addition to those required by the GAAP. It is suggested that such additional financial disclosure can curtail GAAP’s hegemony, curb its promulgators and partially ease some of the existing biases of financial accounting.  Visiting Researcher, Harvard Law School; Research Fellow, Hebrew University of Jerusalem. I extend special thanks to David Gliksberg who had an important impact on this study. I also thank Barak Medina, Dan Segal, Eyal Zamir, Tomer Broude, Assaf Hamdani, Ilan Benshalom, Avi Tabbach, Omri Ben-Zvi, Efi Zemach, Yehudit Dori Deston, Hadar Jabotinsky and Olga Frishman for helpful comments, discussions and advice at earlier stages of this work, and two anonymous referees for their valuable comments. As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) I. INTRODUCTION Stock-market investments, executives’ compensation schemes, utility rate regulation and taxation are all examples for contractual or statutory arrangements that are tied in one way or another to corporations’ financial records and hence to the accounting standards regulating them.1 These standards are known as “generally accepted accounting principles” or, by their acronym, “GAAP.” Although the GAAP has tremendous effects on the financial environment of every person, corporation and institution in modern society,2 GAAP standards themselves do not attract much legal attention.3 The instances in which the substance of the standards – as opposed to the compliance thereof4 – is adjudicated in court or regulated by Congress or the SEC5 are very rare.6 1 See, e.g., William P. Hackney, Accounting Principles in Corporation Law, 30 L. & CONT. PROB. 791 (1965); Peter F. Pope & Anthony G. Puxty, What is Equity? New Financial Instruments in the Interstices between the Law, Accounting and Economics, 54 MOD. L. REV. 889 (1991); Lawrence A. Cunningham, Private Standards in Public Law: Copyright, Lawmaking and the Case of Accounting, 104 MICH. L. REV. 291 (2005). 2 See, e.g, Stuart Burchell et al., The Roles of Accounting in Organizations and Society, 5 ACCT. ORG. & SOC. 5 (1980) (reviewing how accounting is implicated in both organizational and social practice); and Bruce G. Carruthers & Wendy Nelson Espeland, Accounting for Rationality: DoubleEntry Bookkeeping and the Rhetoric of Economic Rationality, 97 AM. J. SOC. 31 (1991) (reviewing the role of double-entry bookkeeping in enhancing rationality and furthering the development of capitalist methods of production). 3 See also ROBERT VAN RIPER, SETTING STANDARDS FOR FINANCIAL REPORTING: FASB AND THE STRUGGLE FOR CONTROL OF A CRITICAL PROCESS, 1 (1994). 4 When accounting issues do get to court, cases usually concern issues of compliance with GAAP. Neither the legitimacy of the standards, their soundness, nor the social liabilities of the institutions that promulgate the standards, are challenged. The standards are taken for granted, and charges are against those who ostensibly did not follow them meticulously. Among such cases are shareholder suits brought against firms' management for lack of sufficient disclosure (e.g., Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011) (a plaintiff claim for securities fraud based on a pharmaceutical company's failure to disclose reports of adverse events associated with a product)); or malpractice suits brought against auditors for not discovering financial frauds (e.g., Ernst & Ernst v. Hochfelder et al. 425 U.S. 185 (1976) (Ernst & Ernst, an accounting firm, failed to expose an escrow account fraud plan committed by the president of the brokerage firm whose statements the firm audited, and was sued by a client of the brokerage firm for negligence). 5 See Omar Ochoa, Accounting for FASB: Why Administrative Law Should Apply to the Financial Accounting Standards Board, 15 Tex. Rev. L. & Pol. 489 (2010) for a list of the theoretical mechanisms available for challenging accounting standards. 6 VAN RIPER, supra note 3 at 70; See Stephen A. Zeff, The Rise of “Economic Consequences,” J. Accountancy 56 (Dec. 1978) [hereinafter: Zeff Economic Consequences] and Stephen A. Zeff, Political ͆Lobbying͇ on Proposed Standards: A Challenge to the IASB, 16 ACCT. HORIZONS 43 [hereinafter: Zeff Lobbying] for a list of occasions in which the Congress or the SEC intervened in the GAAP. As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) The discernable legal indifference towards accounting issues other than those related to obedience7 can be understood, and presumably justified,8 based on a legal perception that sees GAAP as a set of technical rules developed by professionals exclusively for the efficient transfer of financial information using a pre-defined set of financial terms – a “dictionary.”9 As long as all discourse participants use the same terms, it does not matter what the terms are;10 however, deviance from consensual terminology harms the effectiveness of discourse, especially the comparability characteristic of reported data,11 and must therefore be legally regulated.12 The dictionary nature of GAAP suggests that accounting standards are neutral, i.e., lacking any impact in and of themselves on the distribution of power or wealth in society.13 The accepted convention of entering credit on the right side of the ledger and debit on the left, for example, could have been the other way around, and nothing in current reality would have changed. No social group’s status would be better or worse off as a result, nor would wealth or power be differently distributed.14 7 E.g., Kurt S. Schulzke, Wink, Wink, Nudge Judge: Persuading U.S. Courts to Take Accountants Seriously in Federal Securities Cases, with Help from the U.K. Companies Act, 16 TENN. J. BUS. L. 231 (2015) (discussing federal courts’ tendency of ignoring accounting standards content while focusing on a general-factual question of whether investors were misled by the reports). 8 See e.g. WILLIAM H. BEAVER, FINANCIAL REPORTING: AN ACCOUNTING REVOLUTION 196 (1st ed. 1981) (resting accounting regulation rational on the premise that a public agency has a comparative advantage in forming collective agreements). 9 See, e.g., Douglas W. Hawes, Whither Accounting and the Law? A Comparative Analysis of the Sources of Accounting Authority in the Light of International Developments, 2 J. Comp. Corp. L. & Sec. Reg. 195 (1979) (diminishing the legal implications of accounting standards hence advocating national governments to incorporate international standards automatically into domestic law and practice); George Mundstock, The Trouble with FASB, 28 N.C.J. INT'L L. & COM. REG. 813, 822-823 (2003) (dismissing a practical defense for private promulgating of accounting standards that “wrongly assumes that there are neutral and transparent accounting principles”). 10 See, e.g., Credit Union Nat. Ass'n, Inc. v. American Inst. of Certified Pub. Acct., 832 F.2d 104, 108 (7th Cir. 1987) (seeing GAAP as axioms intended simply to make financial reports more consistent, and thus easier to understand); Edmund W. Kitch, Book Review, 47 U. CHI. L. REV. 394, 401 (1980) (addressing accounting as a conventional language that inter alia do not affect marketprice valuation of companies under the efficient-market hypothesis). 11 See infra note 53. 12 Frank H. Easterbrook; Daniel R. Fischel, Mandatory Disclosure and the Protection of Investors, 70 VA. L. REV. 669, 701 n.39 (1984) (suggesting to allow the accounting profession to establish the standards by common usage and then to prevent significant and misleading deviations from that usage). 13 See, e.g. David Solomons, The Politicization of Accounting, J. ACCOUNTANCY 65 (Nov. 1978) (arguing that although accounting expressions have de-facto economic consequences, the end product of accounting is a system of measurement – a “financial map” that represents facts, hence selectivity in data represented does not “rob” the map of its neutrality). 14 However, once a decision was made to enter credit on a specific side, deviation from existing consensus has an effect on society and on the integrity of the accounting discourse, and therefore compliance matters even under pseudo-neutral GAAP. Using Scrabble as an example: It does not matter which dictionary we choose to use in the game as long as decision is made before the pieces are distributed. Once the pieces are distributed, a player cannot change the dictionary to better match his pieces. A change of dictionary in the middle of a game, affects games results, unlike the preliminary (ab initio) selection thereof. As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) This article challenges such beliefs about financial accounting and the GAAP.15 In contrast to the consistent message conveyed by FASB chairmen,16 I argue that the GAAP is not neutral but political; meaning that, financial accounting has a substantive pre-determined effect on the distribution of power and wealth in our society (hereafter – a “political” effect).17 I further argue that viewing GAAP rules merely as definitional rules, i.e., as rules that only provide definitions for a discourse without affecting its content, and whose establishment by private accounting professionals lacks any political consequences or yields any special social responsibilities and duties,18 is incorrect and harmful.19 Specifically, this article argues that a legal misconception exists regarding financial accounting’s true nature; that misconception resulted in the extraordinary20 scrutiny-immune promulgation by private entities of political financial accounting that implies a biased agenda that prefers the investor perspective over contrary or other perspectives, thereby establishing a skewed financial perception of reality that subordinates the social order entirely to investors’ objectives.21 By arguing that accounting standards are not neutral, this article draws a novel picture of financial accounting, one that turns the legal and social perceptions of financial accounting on their head. I expose GAAP as a political institution:22 While modelling our financial understanding and impacting contemporary social order, GAAP's inherent political agenda leads financial accounting to serve certain parts of society at the expense of others. See e.g. VAN RIPER, supra note 3 at 2 (“Laypeople who lack the advantage of having taken at least Accounting 101 in college are likely to assume that the art is basically arithmetical…”); a very early indication of such beliefs regarding accounting, prevailed not only by laymen, is also presented in and discussed by Maurice C. Kaplan & Daniel M. Reaugh, Accounting, Reports to Stockholders, and the SEC, 48 YALE. L. J. 935 (1939) (“The extent of the judgment factor in accountancy is not widely appreciated by investors – statistics and figures inevitably lend an air of mathematical certainty”, id. at 942). 16 VAN RIPER, supra note 3 at 23-24 (quoting Armstrong, Kirk and Beresford – FASB chairmen from 1973 to 1997 – arguing that standards merely portray economic reality, without implying an agenda). 17 See Brandon Gipper, Brett J. Lombardi, & Douglas J. Skinner, The Politics of Accounting Standard-Setting: A Review of Empirical Research, 38 AUSTL. J. MGMT. 523, 525 (2013) (discussing empirical research of lobbying the accounting standards-setting process and the incentives involved). 18 Waters v. Autuori, 676 A.2d 357 (Conn. 1996). 19 See, e.g, Robert H. Heidt, Damned for Their Judgment: The Tort Liability of Standards Development Organizations, 45 WAKE FOREST L. REV. 1280 (2010) (although advocating dismissals of negligence cases against private standard-setters in general, the author objects to eliminating their tort liability altogether). 20 As discussed in Section VI.C., unlike accounting standard-promulgators, other private standard-setters are generally subject to tort liability for negligence in suggesting standards (id.). 21 Unsurprisingly, Gipper et al., supra note 17 indicate a unique influence of the financial community on standard-setting. 22 Accounting is an institution in the Veblenian sense - a habit of thought by a large group of people, see, Robert R. Sterling, A Statement of Basic Accounting Theory: A Review Article, 5 J. ACCT. RES. 95, 99 (1967). 15 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) All in all, the official decision to delegate the active role of financial accounting standard setting to a private, non-governmental organization (the FASB) was made a little less than half a century ago, after substantial public deliberation.23 Normatively speaking, the reasoning behind it is still valid today24 whereas pragmatically speaking, the growing use worldwide of IFRS25 – another international set of accounting standards established by a private organization – indicates that the privatization of accounting standards is effective. Hence, this article’s main objective is not to change the general regulatory model currently used for accounting standards-setting,26 but rather to draw attention to the legal misconception of the GAAP, its resulting social consequences and to a recently SEC-originated development that can affect existing circumstances. The latter would allow domestic issuers to disclose supplemental (non-reconciled) IFRSbased financial results in addition to those required by the GAAP, an option recently discussed by SEC leadership,27 which might curtail GAAP’s hegemony over the 23 In 1971, a public committee (known as the Wheat Committee) was formed to study the establishment of accounting principles and to make recommendations for improving the process. One threshold question which the Committee considered was: Should financial accounting standards be formulated by a governmental or a private body? (REPORT OF THE STUDY GRP. ON ESTABLISHMENT OF ACCOUNTING PRINCIPLES, AM. INST. CPAs, ESTABLISHING FINANCIAL ACCOUNTING STANDARDS, Ch. 5 (1972) [hereinafter: WHEAT REPORT]). The Committee reached the conclusion that this task should continue to be shouldered in the private sector, subject to appropriate review by the SEC. The committee recommended the formation of a Financial Accounting Foundation and a Financial Accounting Standards Advisory Council, and a new rules body. That body, the FASB, was established the following year. See, Wheat Committee, in HISTORY OF ACCOUNTING: AN INTERNATIONAL ENCYCLOPEDIA, 615-16 (Michael Chatfield & Richard Vangermeersch eds., 1996)). Shortly after the Committee's recommendations were implemented, the privatization of accounting standards setting was further publicly debated, and in fact, heavily criticized during the 94th Congress (1975-1977). However, the implementation of Committee's recommendations was upheld and the new FASB continued its job in preparing accounting standards. See, STAFF OF S. COMM ON REPORTS, ACCT. & MGMT. OF THE COMM. ON GOV'T OPERATION, 94th CONG., STUDY ON ACCOUNTING ESTABLISHMENT (Comm. Print 1976). 24 See, e.g., William W. Bratton, Private Standards, Public Governance: A New Look at the Financial Accounting Standards Board, 48 B.C. L. Rev. 5 (2007); Walter Mattli & Tim Buthe, Global Private Governance: Lessons from a National Model of Setting Standards in Accounting, 68 Law & Contemp. Probs. 225, 230 et seq. (2005); and VAN RIPER, supra note 3 at 89 (all emphasize private sector’s highest levels of technical expertise and experience so as resistance to political pressures); Kitch, supra note 15 at 401 (arguing that the delegation to the accounting profession is a device for preserving flexibility in a system otherwise biased toward rigidity); Hawes, supra note 9 at 210 (arguing governments operate too slowly in response to changes needed in accounting). Compare Mundstock, supra note 24 at 817-24 (arguing against these justifications). 25 As of this writing, more than 100 countries apply IFRS; A detailed survey of the worldwide use of international accounting (IFRS) is published by the IFRS Foundation IFRS, Jurisdiction Profiles, http://www.ifrs.org/Use-around-the-world/Pages/Jurisdiction-profiles.aspx (last visited July 3, 2016). For more about IFRS adoption, see Mundstock, supra note 24 at 841-845; Israel Klein, International Accounting Standards (IFRS) and National Accounting Sovereignty: A Case Study of Germany and Israel, 133 HUJI DAAD CTR. GER. STUD'S WORKING PAPER (2014). 26 From non-governmental standard-setting to a full, or partial, governmental accounting standards-setting and etc., see WHEAT REPORT, supra note 23, 21-24. 27 James Schnurr, Chief Accountant, Sec. & Exch. Comm’n, Remarks before the 2015 Baruch College Financial Reporting Conference, (May 7, 2015) http://www.sec.gov/news/speech/schnurrremarks-before-the-2015-baruch-college-financial-reporti.html; James Schnurr, Chief Accountant, As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) accounting discourse and as a result, ease existing political biases in financial accounting. This article proceeds as follows: In the next section, I discuss financial accounting's mechanisms. I explain how the use of a consensual set of financial terms allows an efficient and effective exchange of financial information, and how financial accounting reveals and constructs (“synthesizes”) financial meaning and economic concepts out of presumably non-financial affairs – a process which substantively affects society’s financial understanding In the section that follows (section III), I analyze the normative structure that governs accounting discourse and the role private parties play in setting its norms – circumstances resulting in extreme power given to those parties over society’s financial perspective. In section IV, I focus on the effects accounting norms have on society. I show how the importance of a company's financials causes accounting norms (and their private promulgators) to gain a significant effect on the conduct of statement preparers and on social, political and legal arrangements that utilize accounting financial outcomes. In section V, I argue that the GAAP, and therefore accounting discourse, are based on a predetermined, biased and univalent measurement perspective – that of investors, which ignores other alternative perspectives (e.g., consumers, employees, the general public etc.) that yield different, and sometimes contradictory, financial results. In section VI, I discuss the legal misperception of financial accounting's political nature and its outcomes as reflected in three prominent accounting court cases. In Section VII, I discuss the possible effect that allowing domestic issuers to disclose supplemental IFRS-based financial results might have on the current situation. Section VIII summarizes and concludes. II. FINANCIAL ACCOUNTING MECHANISMS A. Accounting as a Language Contemporary textbooks describe financial accounting as the “language of business,”28 allowing management, analysts and other interested parties in the corporation to discuss its financial performance and exchange opinions and estimates regarding its status and future. The transfer of information, generated mainly by the corporation to external parties, allows those that are not part of its Sec. & Exch. Comm’n, Remarks before the 2014 AICPA National Conference on Current SEC and PCAOB Developments, (Dec. 8, 2014) http://www.sec.gov/News/Speech/Detail/Speech/1370543609306 (discussing a potential alternative of allowing domestic issuers to provide IFRS-based information as a supplement to U.S. GAAP ); Mary Jo White, Chair Accountant, Sec. & Exch. Comm’n, Remarks at the Financial Accounting Foundation Trustees Dinner, (May. 20, 2014) https://www.sec.gov/News/Speech/Detail/Speech/1370541872065 (discussing more generally the incorporation of IFRS into the domestic capital markets). 28 See e.g., CLYDE P. STICKNEY & ROMAN L. WEIL, FINANCIAL ACCOUNTING: AN INTRODUCTION TO CONCEPTS, METHODS AND USES, 3 (10th ed., 2003). As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) inner circle to make an informed judgment that facilitates better decision-making regarding the firm.29 The use of financial accounting as a medium for expressing information about a company's financial affairs allows an efficient and effective transfer of that information. Under financial accounting, information is organized in fixed templates and transferred in condensed and exact patterns that optimize users' resources and ease understanding and processing of the information.30 In addition, the use of consensual templates and patterns in the discourse allows the information transferred by one firm to be compared with information provided by other firms. The ability to compare information generated by distinct firms, all following the same financial accounting rules, enhances overall understanding31 and improves the usefulness of the information in decision making. The high degree of efficiency in exchanging financial information is achieved by the use of a consensual set of symbols and expressions to represent recognized financial meanings – an accounting terminology.32 Each symbol in accounting terminology represents a distinct financial concept, calculation and meaning known to the users. Instead of reporting large amounts of raw financial data accompanied by explanations required to make the data available to users, accounting terminology enables the company itself to process the data, summarize it, and then report the outcomes as accounting expressions that are easily consumed by the users.33 The greater the complexity of the information communicated by financial accounting, the greater the savings generated by the use of accounting as a vehicle for financial information. 29 See, e.g., ELDON S. HENDRIKSEN & MICHAEL. F. VAN BREDA, ACCOUNTING THEORY (5th ed., 1992) at 198-226. 30 BEAVER, supra note 8 at 87-115; See also Heidt, supra note 19 at 1264 (discussing similar features of production and design standards). 31 We understand that a lawn is green, since the green of the lawn is very similar the green we see in traffic lights. However, we better understand the meaning of the lawn being green, when we compare it with another lawn that is yellow. We understand that that green is not only a color that is found in grass and traffic lights, but also that it is different than the color yellow; we also understand that the lawn does not necessarily have to be green, it can also be yellow. As the French philosopher Jacques Derrida put it: The process of signification is a play of differences such that no element can function as a sign without referring to other elements that are not themselves present, and every element is constituted on the basis of the trace within it of the other elements of the chain (THOMAS MCCARTHY, IDEALS AND ILLUSIONS ON RECONSTRUCTION AND DECONSTRUCTION IN CONTEMPORARY CRITICAL THEORY, 100 (3rd ed.1995); JACQUES DERRIDA, POSITIONS, 26 (trans. Alan Bass, University of Chicago Press 1981)). 32 The consensual terminology used by financial accounting is made up of a finite number of symbols representing recognized financial concepts. In order for the discourse to be efficient, financial accounting must contain a limited number of symbols (see Charles W. Churchman, Why Measure?, in MEASUREMENT: DEFINITIONS AND THEORIES 83, 88-92 (Charles W. Churchman & Philburn Ratoosh eds. 1959); WILLIAM ANDREW PATON, ACCOUNTING THEORY WITH SPECIAL REFERENCE TO THE CORPORATE ENTERPRISES, ch. II (1922) (discussing accounting’s main symbols). 33 See e.g. Heidt, supra note 19 at 1259-72 (discussing the social value of standards in the context of products manufacturing). As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) Another benefit of using financial accounting terminology is the information’s effectiveness in improving informed decision making.34 Due to the broad acceptance of accounting terminology and its consensual use by distinct reporters35 (e.g., all public companies prepare consolidated reports), accounting parameters of different companies can be compared and provide a better understanding of the financial information,36 as well as more informed decision making. B. Synthesizing Facts into Financial Meanings An example of an accounting expression is "$1000 in Inventory." In this case, the accounting expression contains a concept combined with a number. The verbal part of the expression, i.e., "Inventory," refers to an accounting category that represents a financial concept – business inventory – whereas the number expresses its monetary value. The whole expression – "$1000 in Inventory" – symbolizes goods held by the company, planned to be sold by the company in the due course of business, and which are valued at one thousand dollars on the company books.37 Company inventory is one piece of information in a broad spectrum of facts expressed by financial accounting. The spectrum limits are determined by the information required by users as one of GAAP's declared objectives of financial reporting is to communicate information that supports informed judgment and improves decision-making.38 Therefore, all relevant items of information that assist in decision making are generally disclosed by accounting. The relevant group of information items disclosed by accounting contains facts that have an obvious and explicit financial meaning for the company, such as the company's cash reserves; however, it also includes facts whose financial value to the company is less obvious, but are still important for the users, e.g., the reputation 34 Id. at 1267. PAUL B. W. MILLER AND RODNEY J. REDDING, THE FASB: THE PEOPLE, THE PROCESS AND THE POLITICS, 15-16 (2nd ed. 1988); QUALITATIVE CHARACTERISTICS OF USEFUL FINANCIAL INFORMATION, Statement of Fin. Accounting Concepts No. 8, ch. 3 para. QC20-QC25 (Fin. Accounting Standards Bd. 2010) [hereinafter FASB, QUALITATIVE of FINANCIAL INFORMATION]. 36 Supra, note 31. 37 Due to the accounting practice of presenting inventory according to the lower of cost and net realizable value for inventory (also known as “lower of cost or market” principle), inventory value in companies’ books represents not only the resources which were invested by the company in comprising the inventory (either by manufacturing or by buying from external suppliers), it also represents the minimal net amount that is expected to be received through realization of the inventory. See, ACCOUNTING STANDARDS CODIFICATION, Topic 330 Inventory, para. 10-35-1B (Fin. Accounting Standards Bd. 2015) [hereinafter ASC, TOPIC 330]. See Murray F. Foss et al., U.S. Dept. of Com., Bureau of the Census, MEASUREMENT OF BUSINESS INVENTORIES, 13-16 (1982) [hereafter: MEASUREMENT OF BUSINESS INVENTORIES] for general explanations regarding inventory measurements, including detailed examples. 38 The GAAP conceptual framework defines the objective of financial reporting as follows: “The objective of general purpose financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders, and other creditors in making decisions about providing resources to the entity.” THE OBJECTIVE OF GENERAL PURPOSE FINANCIAL REPORTING, Statement of Fin. Accounting Concepts No. 8, ch.1 para. OB2 (Fin. Accounting Standards Bd. 2010) [hereinafter FASB, OBJECTIVE OF REPORTING]. 35 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) of the company's products, a fact which obviously has a financial meaning to the company since it affects a company's ability to generate income and is therefore of interest to financial statement users (e.g., imagine how Starbucks' sales would be affected were its coffee to suddenly lose its reputation among coffee consumers).39 However, the exact financial meaning of facts whose effect on a company is not obvious must be first established by financial accounting in order to be reported efficiently and effectively to the users. So, for example, in order for Starbucks to inform its investors about the contribution of its beverages’ reputation to overall sales, the contribution of Starbucks Frappuccino's reputation to Starbucks's general sales of frozen coffee must be determined. Therefore, when GAAP is used to report facts whose financial effects on the company are not self-evident or obvious, their accounting expression is supported by an underlying “financial synthesis process.” In that process, social, legal and even political facts regarding a company's affairs that are important to accounting users, take on a financial form and value determined by GAAP.40 The reputation of a company's products, acquired as part of a merger, for example,41 becomes for the purposes of reporting the merger’s results, an intangible asset that is evaluated, generally speaking, by its fair value, i.e., according to the price a second party would agree to pay in order to buy only the product's manufacturing right (as a proxy for their reputation), or, if such price cannot be determined, according to the prospective monetary contribution of the reputation to the firm's future income.42 The exact economic concept and its monetary value are determined exclusively according to financial accounting rules and the methodology these rules apply.43 39 Nevertheless, due to the accounting principle of prudence (conservatism), the financial value of the reputation of a company’s products, as other intangible properties (IP) internally created by the firm, is only disclosed under GAAP in instances where substantive external evidence exists for the IP being valuable for the company; e.g., when the IP was developed by others, and only then purchased by the company. When reputation, or any other IP, is internally created, IP assets will only be recognized if the company (and therefore the reputation of its products) is acquired by another company, or if the company sells the IP. In both cases, the reputation will be recognized as an IP in the statements of the acquiring entity. An exception to this rule are research and development expenses which, after achieving a certain stage of feasibility, will be recognized as an asset in the developing company’s statements. See, GOODWILL AND OTHER INTANGIBLE ASSETS, Statement of Fin. Accounting Standards No. 142, §§ 9-10 (Fin. Accounting Standards Bd. 2001); BUSINESS COMBINATIONS, Statement of Fin. Accounting Standards No. 141R, § 15 (Fin. Accounting Standards Bd. 2007); and see Michael R. Annis & Brad L. Pursel, Intellectual Property Valuation under U.S. GAAP and the Impact on Intellectual Property Litigation, 38 AIPLA Q. J. 373 (2010) for an expanded review of GAAP IP recognition rules. 40 E.g., TED J. FIFLIS AND HOMER KRIPKE, ACCOUNTING FOR BUSINESS LAWYERS 637 (2nd ed. 1977) (“accounting principles tell us how we can abstract varied human activity into numbers that we can comprehend and compare”) quoted in Mundstock, supra note 24 at 817. 41 See, supra note 39. 42 ACCOUNTING STANDARDS CODIFICATION, Topic 820 Fair Value Measurements, para. 10-35 (Fin. Accounting Standards Bd. 2015); see also Annis & Pursel, supra note 39 at 383-85. 43 As discussed in Section IV infra, once synthesized for the purpose of reporting, the financial meaning given to a fact such as the reputation of a company's products tend to adhere, and becomes As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) GAAP's active role in synthesizing financial meaning is more dominant and common than people have been led to believe.44 The financial value and nature of most facts regarding the firm are actually determined synthetically by financial accounting. Even facts that are presumed to have an obvious and self-evident effect on the company are actually fine-tuned according to accounting rules. For example, in the case of business inventory, although the financial nature and value of the inventory might seem obvious, especially if we think of a simple inventory comprised of items purchased by the company, once inventory is comprised of goods manufactured by the company itself, determining its value becomes less obvious and more similar in its complexity to the evaluation of Starbucks Frappuccino's reputation. Should inventory be evaluated according to manufacturing costs, or according to the consideration the firm is expected to receive in exchange for the inventory?45 Even if the former seems obvious,46 a second set of questions arise: What should be seen as manufacturing expenses, and therefore as cost of inventory, and what should not?47 Should the salary of the factory's cleaning person be allocated to manufactured goods, or should only that of production line workers?48 What about expenses resulting from delivery of goods to stores; is this also part of inventory value or should it be considered expenses associated with sales?49 As can be seen, determining an inventory’s financial value is dependent upon many accounting premises, and although in some cases it might be determined simply, it is an accounting manifestation in most instances. C. Complications in the Accounting Synthesis Process Things become complicated when a single set of facts can be reasonably synthesized into more than one financial meaning, and expressed by more than one accounting expression. In extreme cases, a given set of circumstances, i.e., a single set of facts regarding a firm, can be synthesized as a valuable asset for the company and, at the same time, as a liability levied on the company, thereby potentially resulting in an incoherent accounting depiction between different statement preparers. The potential problems involved in the translation and expression of its exclusive financial meaning. Hence, the financial meaning of facts, whose effect on a company’s financials is not self-evident or pre-quantified, is determined by financial accounting and therefore, by GAAP norms. 44 See, e.g., OBJECTIVES OF FIN. REPORTING BY BUS. ENTER., Statement of Fin. Accounting Concepts No. 1, § 33 (Fin. Accounting Standards Bd. 1978); VAN RIPER, supra note 3 at 23-24 (quoting FASB chairmen emphasizing accounting standards rule in merely portraying economic reality, not effecting it). 45 Robert R. Sterling, "Costs (Historical versus Current) versus Exit Values", 17 ABACUS 93 (1981); MEASUREMENT OF BUSINESS INVENTORIES, supra note 37 at 10 et seq. 46 E.g., Inventory, Accounting Standards Codification Topic 330-10-30-1 (Fin. Accounting Standards Bd. 2015) (“The primary basis of accounting for inventories is cost … cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location…”). 47 ASC, TOPIC 330, supra note 37 para. 10-30-2. 48 Id. 49 Id., para. 10-30-1 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) financial outcomes of such ambiguous factual circumstances can be demonstrated by a hypothetical example: Jack wishes to build on a plot he owns. Because the plot is covered with construction waste, Jack contacts a scrap dealer named Jill, who is interested in the scrap metals mixed in the construction waste. Jill makes a binding commitment to clear Jack's plot in 30 days in exchange for all the metal scraps mixed in with the waste. Jack, who wishes to assure Jill will not back out at the last minute, leaving him with a plot full of junk, asks Jill for a deposit of $500 that will assure Jill's seriousness. How will the financial aspects of the contractual arrangement between Jill and Jack be depicted in Jill's financial statements? To be more accurate, how will Jill represent the $500 deposit given to Jack in her books? On the one hand, the $500 deposit can be synthesized to (and expressed as) a new asset for Jill: In exchange for the deposit, Jill has bought the right to clear Jack's plot and take possession of the metal scraps mixed in with the construction waste, a transaction that should result in recognizing an asset worth $500.50 On the other hand, it can be depicted as a liability for Jill or, a contingent loss: Jill is obligated to clear the land and will lose the deposit and might even be sued for other collateral damages, if she backs out.51 Hence, two possible accounting expressions are available. The arrangement can be expressed as an asset in Jill's statements, or it can be expressed as a liability. Left in the hands of the financial statement preparer, i.e., Jill's accountant, the final synthesized financial expression may be subject to opportunism on Jill's part. If she wishes to present optimistic expectations, e.g., in a presentation made to potential investors, then the agreement and the deposit will be expressed as an asset, suggesting benefits expected by Jill. However, if she wishes to present pessimistic financial results, e.g., for tax purposes, on her K1 tax return, then the deposit is expressed as a liability for Jill, emphasizing the obligation levied on Jill due to the agreement, and the probable loss. If Jill expresses her contract as a liability, while other scrap dealers describe their contracts as assets, Jill's financials will not be very useful, in the best case, and in the worst case, will be misleading. In order for financial accounting to fulfil its intended purpose, i.e., transfer of financial information in an effective and efficient manner that enables informed judgment and better decision-making, consensual depiction must prevail.52 50 And derecognizing an asset of $500 cash. Above all, if Jill now finds a more lucrative opportunity, and wishes to exit the contract, it becomes a liability – in a non-accounting context, as well – she must fulfil in order to be able to enter into any other transaction. 52 Churchman, supra note 32 at 87; see also Lawrence A. Cunningham, SEC's Global Accounting Vision: A Realistic Appraisal of a Quixotic Quest, 87 N.C. L. REV. passim (2008) (discussing the importance of comparability in accounting); VAN RIPER, supra note 3 at 55-67 51 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) Who regulated the consensus and what are its characteristics? The required consensus is created and safeguarded by rules that regulate the use of accounting terminology – “accounting norms” – which presumably prevent contradictory uses of accounting expressions that can harm the discourse,53 and while doing so – also determine its characteristics. III. ACCOUNTING NORMS Similar to other normative systems that regulate how people conduct their affairs,54 the accounting consensus is governed by multiple layers of norms set by more than one player.55 A. Layer I: GAAP's Normative Grounds Financial accounting and GAAP are often treated as interchangeable terms. However, accounting practice and generally accepted accounting principles (GAAP) are two separate things. While the former is in essence a methodology for maintaining business accounts that began in the 13th and 14th centuries in northern Italy and gradually developed into the form known to us today, i.e., double-entry bookkeeping,56 the latter is a modern57 body of doctrine that contains the rules governing the methodology.58 (discussing the controversy following 1975 Congressional demand for a single accounting practice for oil and gas production). 53 See, Comparability, in HISTORY OF ACCOUNTING: AN INTERNATIONAL ENCYCLOPEDIA, 13944 (Michael Chatfield & Richard Vangermeersch eds.,1996). 54 See, e.g., LAWRENCE FRIEDMAN, THE LEGAL SYSTEM: A SOCIAL SCIENCE PERSPECTIVE, 6-11 (1975) (attempting to define a concept of a “legal system”). 55 Cf., HENDRIKSEN & VAN BREDA, supra note 29 at 234-45; Hawes, supra note 9. 56 HENDRIKSEN & VAN BREDA, supra note 29 at 33-36. However, according to some researchers, the origins of double-entry bookkeeping go back to the seventh millennium BC(!), see, e.g., RICHARD MATTESSICH, THE BEGINNINGS OF ACCOUNTING AND ACCOUNTING THOUGHT: ACCOUNTING PRACTICE IN THE MIDDLE EAST (8000 B.C. TO 2000 B.C.) AND ACCOUNTING THOUGHT IN INDIA (300 B.C. AND THE MIDDLE AGES) (2000). 57 The origins of GAAP as a body of doctrine associated with accounting and serving as an explanation of its practices and as a guide in the selection of conventions and procedures to be followed, are attributed to the 1917 issuance of the American Institute of Accountants (AIA) “Uniform Accounting” document, which mainly stressed the audit steps necessary for a balance sheet audit, but did however include what is now called GAAP (see Generally Accepted Accounting Principles in, HISTORY OF ACCOUNTING: AN INTERNATIONAL ENCYCLOPEDIA, 274-75 (Michael Chatfield & Richard Vangermeersch eds.,1996); Donna M. Nagy, Playing Peekaboo with Constitutional Law: The PCAOB and Its Public/Private Status, 80 NOTRE DAME L. REV. 975, 1072 (2005). 58 GAAP norms are technically defined by the AICPA as, “Uniform minimum standards of and guidelines to financial accounting and reporting. Currently, the FASB, the Governmental Accounting Standards Board (GASB) and the Federal Accounting Standards Advisory are authorized to establish these principles.” (American Institute of Certified Public Accountants, Glossary of Terms, Acronyms, and Abbreviations (2014); but see Ronald E. Large, SEC Accounting Series Release No. 150: A Critical Analysis, 54 Ind. L.J. 317, 329 (1979) for a slightly different definition of generally accepted accounting principles). Although the AICPA Glossary defines GAAP as including financial standards promulgated by the As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) What causes GAAP to dominate contemporary accounting discourse? Why are GAAP and financial accounting treated interchangeably? Two distinct sources can be ascribed as empowering GAAP's normative status. The first is SEC regulation,59 requiring public companies to prepare and submit financial statements prepared in accordance with generally accepted accounting principles.60 The second is the common use of GAAP by market firms, and even in cases where no regulatory obligation for GAAP implementation exists, e.g., in the case of private companies.61 The de-facto widespread use of GAAP as the exclusive set of accounting rules, and its SEC-bestowed authoritative status over public companies,62 both serve to confer special normative status on GAAP vis à vis the public. In the market sphere, GAAP is seen by accountants and the general public as the most appropriate GASB and the Federal Accounting Standards Advisory, this article refers to GAAP only in the context of its use by non-governmental entities. 59 The federal securities laws set forth the broad authority and responsibility of the SEC to prescribe the methods to be followed in the preparation of accounts and the form and content of financial statements to be filed under those laws. For example § 19(a) of the Securities Act of 1933 (15 U.S.C. § 77s(a) (2012)) and § 13(b) of the Securities Exchange Act of 1934 (15 U.S.C. § 77s, § 78m (2012)) grant the Commission authority to prescribe the items or details to be shown in the balance sheet and the earnings statement, and the methods to be followed in the preparation of such financial reports submitted to the Commission and published to investors. In addition, regulation S-X, which sets the form and content of financial statements, explicitly requires that financial statements be prepared using U.S. GAAP: “Financial statements filed with the Commission which are not prepared in accordance with generally accepted accounting principles will be presumed to be misleading or inaccurate, despite footnote or other disclosures, unless the Commission has otherwise provided.” (17 C.F.R. §210.4-01 (2012)). 60 The Commission has historically looked to the standard-setting bodies designated by the accounting profession to provide leadership in establishing and improving accounting principles, hence empowering the standards promulgated by these bodies with normative supremacy over the accounting conduct of public companies. See, Admin. Pol'y on Fin. Statements, Accounting Series Release No. 4, [11937-1982 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶72,005, at 72,005 (Apr. 25, 1938) [hereafter: ASR No. 4] (quoted in its entirety in Mundstock, supra note 24 at 825-826); Statement of Pol'y on the Establishment & Improvement of Acct. Principles and Standards, Accounting Series Release No. 150, 3 SEC Docket 275 (Dec. 20, 1973) [hereafter: ASR No. 150]; Comm'n Statement of Pol'y Reaffirming the Status of the FASB as a Designated Private-Sector Standard Setter, Securities Act Release No. 8221, Exchange Act Release No. 47,743, 80 SEC Docket 139 (Apr. 25, 2003); see Large, supra note 58; Nagy, supra note 57 at 987; Jacob L. Barney, Beyond Economics: The U.S. Recognition of International Financial Reporting Standards as an International Subdelegation of the SEC's Rulemaking Authority, 42 V and. J. Transnat'l L. 579, 584587 (2009). See also Arthur Andersen & Co. v. SEC, [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) 96,374 (D.C N.D. 111. 1978) (a failed attempt to challenge ASR 150 legitimacy; the court concluded with characterizing the release as only a method the SEC will evaluate accounting principles and not as a substantive rule). 61 Petro Lisowsky & Michael Minnis, Which Private Firms Follow GAAP and Why?, Chicago Booth Research Paper No. 14-01, 19 (September 11, 2015) Available at SSRN: http://ssrn.com/abstract=2373498 (indicating a GAAP-use ratio of 79% among private-companies examined in the study; however preparing audited GAAP statements ration is lower). 62 Another source that can empower GAAP normative status is stock exchanges’ internal regulations that can require the use of GAAP in a traded company’s financial reports (See, e.g., JOEL SELIGMAN, TRANSFORMATION OF WALL STREET 46-49 (1982)). As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) language for use in describing corporations' financials63 and hence, as rules that market participants should follow.64 GAAP becomes the custom in the market, resulting in authorized financial statements to be seen as such, i.e., as statements that are relied upon in financial decision making if, and only if, a certified public accountant has given his unqualified opinion that the statements follow generally accepted accounting principles.65 Alternative accounting principles are simply not treated as legitimate by market participants.66 B. Layer II: GAAP Norms The second layer in the normative structure governing accounting discourse consists of the GAAP norms themselves.67 Following the decision to delegate accounting standard-setting,68 norms prescribed by private organizations, rather than regulator-instituted norms,69 constitute the major portion of accounting norms regulating the discourse.70 More than one party is endowed with the legal or social legitimacy to prescribe GAAP, and therefore engage in privately promulgating accounting standards:71 1. Financial Accounting Standards Board (FASB) 63 E.g. Lisowsky & Minnis, supra note 61 at 4 (indicating that audited GAAP statements play a managerial monitoring role and an informational role in valuing equity, particularly at the time of equity transactions). 64 Nonetheless, GAAP supremacy over accounting discourse is somehow curtailed by other than SEC regulations. Some regulators, such as the Federal Communications Commission (the FCC), are empowered with the authority to compel regulated entities, as necessary to promote their distinct and exclusive regulatory objectives, to maintain accounts according to rules different than GAAP (see 47 U.S.C § 220 (2012)). Nevertheless such lex specialis accounting rules are only common in a number of regulated markets and apply for only limited uses – such as rate determination for incumbent local exchange carriers – therefore, GAAP supremacy over the discourse as a whole is not truly affected. 65 Economic theory suggests that firms will generate audited GAAP financial statements even in the absence of regulatory mandates. However the extent and conditions under which firms actually provide audited statements are empirical questions (Lisowsky & Minnis, supra note 61 at 9). Although cumulative findings of empirical studies indicate that private firms do not produce audited statements (id. at 10-11, 19-21), detailed findings show that in instances where the statements have increased weight in understanding firm’s status (e.g., high level of intangible or ownership dispersion) the tendency for providing audited statements increases (id. passim). 66 E.g., studies report that capital providers prefer GAAP basis financial statements (id. at 12). 67 For a review of internal GAAP hierarchy, see Patrick Colabella et al., FASB Proposes to Adopt Its Codification as U.S. GAAP, 24 Com. Lending Rev. 37 (2009). 68 ASR No. 4, supra note 60, is seen as the foundation for accounting’s private standard-setting in the United States, see Mundstock, supra note 24 at 825-826; Nagy, supra note 57 at 984-989. 69 See e.g. United States v. Winstar Corp. 518 U.S. 839, 846-47 (1996) (discussing the use of regulatory accounting principles (RAP) , in the early 1980s, as a replacement of GAAP for the purposes of determining compliance with bank's capital requirements); Bratton, supra note 24 at 1618. 70 Corporate Accounting Practices: Is there a Credibility GAAP?: Hearing before the Subcomm. On Capital Mkts., Ins., & Gov't Sponsored Enters. of the Comm. Fin. Serv., 107th Cong. 99-101 (2002) (statement of Robert K. Herdman, Chief Accountant, SEC). Bratton, supra note 24. 71 Mundstock, supra note 24 at 816-24. As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) The most prominent private organization involved in creating accounting norms is the FASB, a private organization,72 whose board members are appointed by another private foundation, a non-stock Delaware corporation: The Financial Accounting Foundation (FAF).73 The FASB derives its legitimacy (and authoritative powers)74 from the Securities acts and SEC recognition.75 Historically speaking, the SEC exercises its delegated powers to set accounting principles for public companies (conferred by Securities acts) by looking to standard-setting bodies designated by the accounting profession to provide leadership in establishing and improving accounting principles.76 In the beginning, the SEC relied on the American Institute of Certified Public Accountants. Since the enactment of the first Securities Act (1933) and until 1959, this was the AICPA's Committee on Accounting Procedure (CAP).77 The CAP was then replaced by an enhanced version of accounting standards setter (although still governed by the AICPA), the Accounting Principles Board (APB),78 which lasted until 1973, when it was replaced by the Financial Accounting Standards Board (FASB). Since its establishment in 1973, the SEC has relied on the FASB – a private organization, completely separate from the AICPA – to prescribe accounting standards.79 Recognizing FASB standards as the only standards with substantial authoritative SEC support80 granted the FASB with a mandate81 to set accounting standards for public companies regulated by the Securities acts and the SEC. The FASB gained additional authority over non-public firms as well (those not subject 72 The FASB is an independent private-sector organization operating with the goal of establishing and improving standards of financial accounting and reporting that foster financial reporting by nongovernmental entities that provides decision-useful information to investors and other users of financial reports. The organization is part of a structure that includes the Financial Accounting Foundation, the FASB, the Financial Accounting Standards Advisory Council (FASAC), the Governmental Accounting Standards Board (GASB), and the Governmental Accounting Standards Advisory Council (GASAC) (FACTS ABOUT FASB, http://www.fasb.org/facts/index.shtm (last visited July 3, 2016)). 73 The FAF is an independent, private-sector organization with responsibility for the oversight, administration, and finances of its standard-setting boards, the FASB and the GASB. It is a nonstock Delaware corporation that operates exclusively for charitable, educational, scientific, and literary purposes within the meaning of § 501(c)(3) of the Internal Revenue Code (FACTS ABOUT FAF, http://www.accountingfoundation.org/cs/ContentServer?c=Page&pagename=Foundation%2FPage %2FFAFSectionPage&cid=1176157790151 (last visited July 3, 2016)). 74 Authority over public companies subject to SEC regulation. FASB authority over private companies is derived from AICPA recognition, see infra. 75 Supra note 60. 76 ASR No. 150, supra note 60; see, STEPHEN A. ZEFF, FORGING ACCOUNTING PRINCIPLES IN FIVE COUNTRIES: A HISTORY AND AN ANALYSIS OF TRENDS, 134 et seq. (1972); Mundstock, supra note 24 at 825-830; Nagy, supra note 57 at 986. 77 See ZEFF, supra 76 at 134-40. 78 Id. at 167-73. 79 Supra note 60. 80 Id. 81 See Cunningham, supra note 52 at 28-33. As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) to SEC regulation) once it was designated by the AICPA Council to establish accounting principles that bind AICPA members in auditing non-public companies:82 Rule 202 of AICPA Code of Conduct83 requires a member who performs auditing, review, compilation, management consulting, tax, or other professional services to comply with standards promulgated by Council-designated bodies, among them, the FASB.84 2. The American Institute of Certified Public Accountants The Institute is the world’s largest member association representing the accounting profession,85 and enjoys broad acceptance among parties involved in preparation of accounting statements, AICPA members and non-members alike. Along with designating FASB as the accounting standards promulgator for its members, the AICPA itself remained a prominent and independent prescriber of accounting norms through the work of four of its senior committees: (1) The Accounting and Review Services Committee (ARSC), the (2) Auditing Standards Board (ASB) and the (3) Management Consulting Services Executive Committee. The ARSC is designated by AICPA to issue pronouncements in connection with the unaudited financial statements of non-public entities; the ASB, to develop comprehensive standards that enable high-quality audit services to non-issuers; and, the Management Consulting Services Executive Committee to issue pronouncements in connection with consulting services provided by Institute members. Although these committees are not designated to promote or promulgate accounting standards par excellence, as further demonstrated,86 their pronouncements affect accounting issues. In addition to these three committees, which issue authoritative Institute publications and not standards, the AICPA is more directly involved in accounting standards promotion and promulgation via the (4) Financial Reporting Executive Committee (FinREC).87 The FinREC is considered the Institute’s senior technical 82 VAN RIPER, supra note 3 at 27. CODE PROF'L CONDUCT § 1.310.001 [Prior reference: para .01 of ET § 202] (AM. INST. CPAs, amended Oct. 26, 2015), http://www.aicpa.org/Research/Standards/CodeofConduct/DownloadableDocuments/2014Decemb er15ContentAsof2015October26CodeofConduct.pdf. 84 In a similar fashion, rule 203 prohibits a certified public accountant from expressing an opinion or stating affirmatively that the financial statements are presented in conformance with generally accepted accounting principles if such statements contain any departure from an accounting principle promulgated by bodies designated by AICPA Governing Council to establish such principles. The Council has designated the FASB as such a body and has resolved that FASB Standards constitute accounting principles for the purpose of rules 202 and 203 (CODE PROF'L CONDUCT § 1.320.001 [Prior reference: para .01 of ET § 203] (AM. INST. CPAs, amended Oct. 26, 2015), http://www.aicpa.org/Research/Standards/CodeofConduct/DownloadableDocuments/2014Decemb er15ContentAsof2015October26CodeofConduct.pdf) 85 ABOUT THE AICPA, http://www.aicpa.org/About/Pages/About.aspx (last visited July 3, 2016). 86 See infra Part VI. 87 Formerly known as the Accounting Standards Executive Committee (AcSEC). 83 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) committee for financial reporting88 and is permitted to issue accounting opinions on behalf of the AICPA.89 It focuses on industry-specific issues, and produces Audit and Accounting Guides, Statements of Positions (SOPs) and other accounting pronouncements, which carry accounting standard characteristics. Though some early SOPs have addressed broader financial issues, such as accounting for partnerships, environmental liabilities, etc., in 2002 the Committee agreed to restrict itself to industry-specific accounting guidance,90 and it currently focuses on providing needed guidance on financial reporting issues that standards setters either are not expected to address or are not expected to address in a timeframe that FinREC considers desirable. Although FinREC's accounting publications are not considered a primary source of GAAP upon their issuance,91 they gain strong legitimacy when becoming part of accountants' common practice (as usually happens) and later, when adopted by the SEC or integrated into FASB codification,92 they become an official part of GAAP.93 C. Layer III: GAAP Implementation In their day-to-day occupation with auditing financial statements, accounting firms develop genuine accounting norms. Some are interpretations of existing GAAP standards required for proper application; others are novel accounting norms that provide guidance for rare accounting issues that have not been covered by existing accounting standards. Although the big accounting firms lack clear institutional status – at least in comparison to the status the FASB has over public firms and the AICPA committees over its members – auditing firms maintain a very dominant role in the accounting discourse. Audited clients must adhere to their accountants' stipulations, otherwise their financial statements will not receive an 88 FACTS ABOUT THE FINANCIAL REPORTING EXECUTIVE COMMITTEE, http://www.aicpa.org/InterestAreas/FRC/AccountingFinancialReporting/DownloadableDocuments /FinREC/Facts_About_FinREC.pdf (last visited July 3, 2016). 89 Id.; BYLAWS § 360R (AM. INST. CPAs, amended Jan. 12, 1988). 90 See, STEVEN M. BRAGG, THE ULTIMATE ACCOUNTANTS' REFERENCE: INCLUDING GAAP, IRS AND SEC REGULATIONS, LEASES AND MORE, 23 (3rd ed., 2010). 91 Unlike the ARSC, the ASB and the Management Consulting Services Executive Committee, the FinREC is not included in AICPA Council Resolution Designating Bodies to Promulgate Technical Standards, see CODE PROF'L CONDUCT app. A (AM. INST. CPAs, amended Oct. 26, 2015), http://www.aicpa.org/Research/Standards/CodeofConduct/DownloadableDocuments/2014Decemb er15ContentAsof2015October26CodeofConduct.pdf. However FinREC’s publications, as other publications of AICPA, are still considered “secondary sources” of GAAP in cases where the accounting treatment of a transaction or event is not specified by a pronouncement of the FASB (THE HIERARCHY OF GENERALLY ACCEPTED ACCOUNTING PRINCIPLES, Statement of Fin. Accounting Standards No. 162 (Fin. Accounting Standards Bd. 2008)). 92 See supra note 67. 93 Another highly important player in the accounting arena is the Public Company Accounting Oversight Board (PCAOB), a private-sector corporation created by the Sarbanes–Oxley Act of 2002 to oversee the audits of public companies and other issuers. However, the PCAOB focuses on regulating financial statements’ audit quality and has only a minor effect on accounting issues other than auditing. See, ABOUT THE PCAOB, http://pcaobus.org/About/pages/default.aspx (last visited July 3, 2016). As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) unqualified opinion (and will therefore not be applicable for investors).94 In addition, when financial accounting standards are contemplated and issued by the FASB and the AICPA, prevailing accounting treatments, as applied by the big accounting firms, are taken into consideration and greatly affect final policy decisions.95 Another accounting quasi-norm prescriber are corporations themselves.96 In recording daily business transactions and in interim preparation of comprehensive financial statements, firms make accounting decisions that evolve into accounting norms. These norms regulate the firm's in-house accounting conduct and are created, inter alia, when a company elects an accounting treatment that affects other of the firm’s practices. In part, such decisions are made in the rare cases where the accounting consensus allows more than one legitimate accounting treatment for recording a given transaction,97 or when non-financial matters are synthesized and expressed by accounting terms.98 D. The Limits of Legal Tolerance toward Accounting Norms The normative structure of accounting discourse contains multiple norms prescribed by governmental and private entities.99 Although some of the GAAP's normative foundations result from the legal and social endorsement of the GAAP, the main and most dominant accounting norms, including the GAAP standards themselves, are promulgated exclusively by private institutions. As mentioned in the introduction, the private regulation of accounting in the US is a fait accompli. Nevertheless, the limits of legal tolerance toward the privatization of the accounting discourse, i.e., towards the use of accounting rules promulgated by the FASB, AICPA, accounting firms and corporations themselves, depend on two issues. One is the nature of the promulgated norms and whether they affect nonaccounting social mechanisms that may be important for the general public, e.g., property rights, access to resources, private wealth, etc. And, the second is the nature of accounting standards: Are they neutral and therefore do not have a substantive political effect on social order, whether promulgated privately or by the 94 See Regulation S-X, art. 2 (17 CFR Part 210 (2012)) and FIN. REPORTING MANUAL § 4220.1 (Div. Corp. Fin., updated August 25, 2015) https://www.sec.gov/divisions/corpfin/ cffinancialreportingmanual.pdf. 95 See also e.g. Gipper et al., supra note 17 at 544-49 (discusses studies that show that audit firms lobby directly in their own interests as well as in the interests of their clients) 96 In that context see also Patricia M. Dechow, Amy P. Hutton & Richard G. Sloan, Economic Consequences of Accounting for Stock-Based Compensation, 34 J. ACCT. RESEARCH 1 (1996) (present evidence of management lobbying standards-promulgating directly in their own selfinterest). 97 See, e.g., Zeff Economic Consequences, supra note 6. When a firm prefers one legitimate accounting option over another, the accounting decisions create a private accounting norm that binds the corporation in future cases. All future transactions of the same type and all future representations of the recorded transaction, are made according to that accounting decision. 98 See discussion supra Section III.B. 99 Cf., HENDRIKSEN & VAN BREDA, supra note 29, 234-45; Hawes, supra note 9. As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) government or, do they contain a hidden political agenda, which affects the political social order? Generally speaking, as the general social effects of accounting norms increase and their neutrality decreases, we will be less tolerant towards privatization and require private promulgation to be carefully monitored. And conversely, as nonaccounting effects decrease, and neutrality increases, the legal system should care less about the privatization of accounting standards setting, and be exclusively focused on enforcing compliance. The next section discusses accounting norms’ overall social effects, while the section following that discusses the GAAP political agenda. IV. FINANCIAL ACCOUNTING: A LANGUAGE AND A SOCIAL PRISM When we discuss financial “phenomena” such as a company’s financial value and even a state’s national budget, we see these phenomena through a prism of financial accounting.100 Financial accounting shapes our financial perception of the surrounding world101 primarily because unaided observation, made without knowledge of accounting, cannot provide comprehensive financial understanding of complex commercial affairs. Once affairs become complex, casual observation cannot grasp the overall financial meaning of the cumulative parameters. Financial accounting enables insight into the financial properties of complex commercial affairs, especially those conducted over long periods of time, or by large corporate groups made up of many subsidiaries engaged in synergistic activity. The role financial accounting plays as society's financial prism facilitates two distinct social effects: a downstream effect and an upstream effect. A. Financial Accounting’s Downstream Effect When entities, such as companies and partnerships – and most importantly, their management – know that the firm's activities are expected to be depicted according to financial accounting rules, i.e., that the firm's actions will result in accounting expressions, it causes them to change their conduct so as to fall within accounting's requirements that gain the accounting expression they desire most.102 If no accounting expression existed, entities’ behavior would not be affected by an alien need to conform to external criteria, and entities would behave differently. 100 Cf., Ruth D. Hines, Financial Accounting: In Communicating Reality, We Construct Reality, 13 ACCT. ORG. & SOC. 251 (1988). 101 See TONY TINKER, PAPER PROPHETS: A SOCIAL CRITIQUE OF ACCOUNTING, 28 (1985). 102 In the accounting literature, the downstream effect accounting rules have on preparers’ conduct is termed “economic consequences,” see Zeff Economic Consequences, supra note 6; see David Solomon, Accounting and Social Change: A Neutralist View, 16 ACCT. ORG. & SOC’Y. 287, 291-93 (1991). See also David I. Walker, Financial Accounting and Corporate Behavior, 64 WASH. & LEE L. REV. 927 (2007) (discussing evidence of, and legal aspects related to, the power of accounting to shape corporate behavior). As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) The downstream influence accounting has on entities' conduct, i.e., the pursuit of desirable accounting expressions, has the power to distort economic decision making.103 It affects management's priorities and leads to different decisions than would have resulted if accounting depictions did not exist.104 In consequence, commercial arrangements sometimes take on the most efficient accounting form, i.e., the one that yields the most desirable accounting expression, rather than the most efficient business form, that is, the one that will maximize overall benefits for the firm. A positive accounting expression that shows the firm to be generating profit in the short run does not necessarily mean that the firm and its shareholders actually gain overall positive outcomes,105 to wit, one year before going bankrupt, Enron's reported earnings increased 25% and revenues more than doubled, to over $100 billion.106 The pursuit of favorable accounting expressions causes transaction conditions to be shaped in the form needed to report the numbers, rather than their actual effect on the firm's stability and long term prosperity. As history shows, the tendency toward accounting outcomes might even encourage fraud.107 In extreme cases, accounting considerations can cause executives to engage in ineffective arrangements and sacrifice real resources through unreasonable choices made only in order to generate a plausible accounting expression. A firm, for example, may decide to irrevocably waive its right to appoint directors to the board of a subsidiary it holds and hence, lose any option to affect the subsidiary's managerial decisions and control it, in order to evade the accounting requirements mandating a company to consolidate its financials with the financials of subsidiaries it controls.108 The effect accounting expressions have on management's actions can produce some severe moral hazards created by incentives – in the form of plausible and legitimate accounting expressions – given to managers' actions that negatively affect the firm and others. One such morally ambiguous incentive includes the accounting expression of early debt extinguishment. 1. Early Extinguishment of Debt: Managers versus Creditors 103 E.g. uneconomic hedging of foreign exchange risk in order to minimize earning volatility resulting from the translation of accounting results to the reporting currency, see VAN RIPER, supra note 3 at 32-33; infra note 112 and accompanying text. 104 See, e.g, Sharon Hannes & Avraham Tabbach, Agency Costs and Misrepresentation in Leveraged Firms, 40 J. CORP. L. 99, 142 (2014) (discussing the effect of financial results, and specifically the misrepresentation thereof, on agency costs between shareholders and debt-holder). 105 E.g. Walker, supra 102 at 930 (discussing Kamin v. American Express Co., a case in which directors scarified $8 million in shareholders’ tax saving only to avoid a $26 million reduction in reported earnings). 106 Bethany McLean, Is Enron Overpriced?, FORTUNE, March 5, 2001, at 123. 107 See, e.g., John R. Kroger, Enron, Fraud, and Securities Reform: An Enron Prosecutor's Perspective, 76 U. COLO. L. REV. 57 (2005). 108 ACCOUNTING STANDARDS CODIFICATION, Topic 810 Consolidation (Fin. Accounting Standards Bd. 2015) As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) Early extinguishment of debt is a reacquisition of debt securities by their issuer before the scheduled maturity of the debt (“debt buyback”).109 In debt buyback transactions, the amount paid upon early extinguishment is usually lower than the amount due at maturity, and if the market demand yield increases (above the yield demanded when the debt was originally issued) it is also lower than the present net carrying amount of the debt as recorded on the books.110 In instances of early debt extinguishment, the difference between the value of the debt – as carried on the books – and the amount paid to debt holders at buyback is recorded according to GAAP as profit for the firm.111 GAAP treatment of debt buyback incentivizes a firm's management to take advantage of occasions when the company's debt is traded at lower prices, and therefore at higher yields than when initially issued – e.g., when the market mistrusts the company's stability due to the company's financial underperformance112 – and to buy debt back while generating immediate accounting profits. And yet, at whose expense are such profits created? A strong argument can be made – and specifically in cases where the market value of a company's debt decreases due to management’s poor performance – that these profits are actually made at the expense of firm's creditors, and the transaction is laden with extreme moral hazards.113 The firm that underperformed, causing the debt's price to go down, is now enjoying profits at the expense of its creditors. 109 EARLY EXTINGUISHMENT OF DEBT, Statement of Fin. Accounting Standards No. 26 § 3(a) (Accounting Principles Bd. 1972) [hereinafter APB NO. 26]. 110 According to GAAP, issued debt is measured according to the interest prevailing when the bonds are issued; later changes in the bond's interest (i.e. market demand yield) do not affect the amount of the debt on the books although they change the market price of the bonds. For example, if the firm issued $100,000 10-year zero coupon bonds in an interest environment of 1%, resulting in proceeds of a little more than $90,500 ($100k/(1.01)^10), and a year later – due to a Federal Reserve decision to raise general interest rates, or due to a change in the market valuation of the company's stability – the interest environment changes to 2%, i.e., the market now demands a higher yield, the market price of the same bonds decreases to a little less than $84,000 ($100k/(1.02)^9). However, the bond's book price, determined by the interest prevailing upon debt issuance, i.e., 1%, is $91,434 (($100k/(1.01)^9). Since the increase of one percent (from 1% to 2%) does not affect a company's debt carrying amount on the books though it does change the market price of the debt, the company can buy back its debt at market price ($84,000), which is less than it owes to the creditors according to the debt contract ($100k) and less than the carrying amount of the debt in the books ($91,434). 111 See APB NO. 26, supra note 109 §§ 8, 9, 11 (GAAP sees early extinguishing of debt as identical to early extinguishment of other contracts made in exchange for cash, and is therefore recognized as generating income (or loss) for the firm). 112 In cases when external circumstances cause firm's debt price to decrease (e.g., a change in the Federal Reserve’s interest rate) GAAP's treatment of debt buyback transactions has different consequences: It incentivizes the firm's management to replace existing debt (carrying “old” and low interest) with new, more expensive, debt (issued in the updated and higher interest rate), a step that creates profits in the short term, but results in excessive loss of value for the firm in the long run. See APB NO. 26, supra note 109 § 10. 113 In that context, see also S. P. Kothari, Karthik Ramanna & Douglas J. Skinner, Implications for GAAP from an Analysis of Positive Research in Accounting, 50 J. ACCT & ECON 246, 257-58 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) In addition, the accounting treatment of buyback transactions also incentivizes misuse of resources by troubled companies. Instead of investing funds in healing real business activities – a step which might not culminate with accounting profits – managers are incentivized by GAAP to buy back issued debt, an action which immediately creates a profit on the books.114 2. The Importance of Financial Accounting Expressions for the Firm The effect financial accounting has on the firm is derived by the use of accounting in internal firm mechanisms and a great number of external social, legal and political systems surrounding the firm.115 Accounting expressions play an important role in determining how resources are allocated in society,116 in making hiring and layoff decisions,117 in the compliance with legal duties,118 in granting state benefits,119 and in many other decisions that affect the financial status of our lives.120 While some internal uses of accounting are voluntary and the firm can replace accounting with other assessment tools – e.g., executive bonuses can be tied to parameters other than those determined by the firm's financial statements – other external circumstances in the life of the firm cannot be avoided. For example, when a firm wishes to raise capital from the public,121 it must publish a prospectus which includes financial statements. In addition, the tax system also relies (to some (2010) (discussing conservative accounting rules as a precondition to lending and as a means to prevent transfer of wealth from debt holders to shareholders). 114 When the financial status of a company deteriorates resulting in a decrease in the market price of its trading debt, the fastest way for management to present accounting profits is by carrying debt buyback. The accounting result of any other action, such as an attempt to recover business operations, are uncertain and even if they culminate in success, will not generate immediate reported profits. 115 VAN RIPER, supra note 3 at 4. 116 See, e.g., Cheryl D. Block, Congress and Accounting Scandals: Is the Pot Calling the Kettle Black?, 82 Neb. L. Rev. 365 (2003); JOHN FLOWER, ACCOUNTING AND DISTRIBUTIVE JUSTICE (2010); AHMED RIAHI-BELKAOUI AND JANICE MONTI-BELKAOUI, FAIRNESS IN ACCOUNTING (1996). 117 Accounting is utilized by organizations for profitability evaluation, and therefore determines desirability. Evaluation of department performances and individual worker outputs are made based on accounting records. These result in worker bonus payments and hiring and layoff decisions, all affected by financial outcomes tied to GAAP. See, e.g., Burchell et al., supra note 2 at 5; TINKER, supra note 101 at 83-84. 118 Burchell et al., supra note 2 at 22; infra Section IV.B. 119 These benefits are granted or allocated based on turnover threshold, profitability or other parameters determined by financial accounting. See Burchell et al., supra note 2 at 6; Richard C. Breeden, Thumbs on the Scale: The Role that Accounting Practices Played in the Savings and Loan Crisis, 59 Fordham L. Rev. S71 (1991). 120 E.g., Claudia Schwarz et al., Why Accounting Matters: A Central Bank Perspective, 5 ACCOUNTING, ECONOMICS AND LAW-A CONVIVIUM 42 (2015); United States v. Winstar Corp. 518 U.S. 839 (1996) (supra note 69). 121 According to SEC regulations, more than 35 investors (SEC Regulation D). As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) extent)122 on an entity’s commercial records and therefore, requires at least minimal engagement in accounting activities. The use of financial statement figures in many contractual and statutory arrangements123 enhances the downstream accounting effect on a firm's activities, and simultaneously, also creates another effect for financial accounting – an upstream effect. B. Financial Accounting’s Upstream Effect Social, legal and political arrangements utilize existing accounting depictions as the conduit to the financial character of a company and other parties involved with it. Besides facilitating better understanding of complex transactions in which the firm is involved, ad-hoc understanding of the firm's conduct is also achieved easily, and relatively cost-free, through existing accounting records. However, such use comes with a price. When financial accounting is used in non-accounting systems, accounting conduct gains an influential role over these systems and accounting norms that control the preparation of financial records become a part of the normative structure governing these non-accounting systems.124 Such nonaccounting uses of accounting parameters can affect the functioning of these systems, and may transfer primacy over the system from the pre-designated authority to the accounting standards promulgator. To take one example, in the U.S., under state corporate laws,125 distributions to shareholders are generally regulated according to a “solvency test.”126 Distributions may not be made if they result in the firm not being able to pay its debts as they become due.127 Solvency, and eligibility for dividend distribution, is generally determined by the firm's financial statements.128 Broadly speaking, the excess of the firm's assets over its liabilities is equal to the amount of dividends that the firm is legally permitted to distribute. Hence, accounting's asset (and liability) 122 See infra Section IV.B.2. See supra note 1. 124 See e.g., Douglas J. Skinner, The rise of deferred tax assets in Japan: The role of deferred tax accounting in the Japanese banking crisis, 46 J. ACCT & ECON. 218 (2008) (concludes that Japanese regulators used deferred tax accounting as part of a regulatory forbearance strategy). 125 U.S. corporations are organized under state laws, and different corporation statutes exist according to states. Efforts to harmonize the different corporation laws in the 1940s led to the development of the Model Business Corporation Act (MODEL BUS. CORP. ACT. (2015) [hereinafter MBCA]). MBCA § 6.40 regulates distributions to shareholders. See Josef Arminger, Solvency-Tests – An Alternative to the Rules for Capital-Maintenance within the Balance Sheet in the European Union, 2 ACRN J. FIN. & RISK PERSPECTIVES 1, 2-3 (2013). 126 In Europe, a more formal doctrine, which relies directly on financial statements, is generally used to regulate distribution. The European “capital maintenance” doctrine regulates distribution using two accounting tests: 1. a “balance-sheet test,” which restricts the distribution to shareholders, provided that a company's nominal capital and restricted reserves would be diminished; and 2. “retained earnings test,” also known as a “profit and loss test,” according to which profits of prior periods establish a ceiling for distributions (See Arminger, id at 2). 127 MBCA, supra note 125 § 6.40(c). 128 Id. § 6.40(d). 123 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) recognition rules, which determine what is recorded and expressed as an asset (or a liability) on the books and what is not, play a crucial role in regulating distribution. In fact, the effect of financial statement use in regulating dividend distributions goes beyond mere determination of distributional amounts. The use of accounting statements in regulating distributions also means that accounting norms determine the extent of shareholders' financial exposure to a company's hazardous activities. Since solvency is tested by a company's financial statements, recognizing an accounting liability causes a portion of a firm's profits to become non-distributable. Hence, the question of the extent to which shareholders are exposed to ongoing hazardous activities of the firm is not determined solely by a legal “limited liability” regime, but rather by accounting standards. If GAAP recognizes a company's hazardous activity as risky enough to fulfill the accounting requirements for the creation of an accounting liability,129 then a company's ability to distribute dividends will be reduced in the amount of the accounting-recognized liability, leaving shareholders’ profits “locked in” at the company in order to cover the risk. However, if the risk is not recognized by GAAP as justifying creation of a liability on the books, then no profit is locked-in to cover the hazardous activity, and no shareholder exposure exists.130 The “Normative Boiling Point” For some non-accounting systems, the upstream effect, precipitated by the use of financial statements for regulatory purposes, had become so dominant and disturbing to the system's normative functioning that later regulatory development involved a reduction in the extent of system's use of GAAP figures. Taxed income, for example, was principally computed on the same basis by which the taxpayer regularly computes his income in keeping his books, i.e., GAAP.131 Nevertheless, taxpayers' manipulative use of GAAP rules caused the Supreme Court, in the seminal 1979 case, Thor Power Tool Co. v. Commissioner,132 to subordinate GAAP usage by the tax system to superior tax principles prescribed by the Treasury,133 129 See, ACCOUNTING STANDARDS CODIFICATION, Topic 405 Liabilities, para. 10-35-1B (Fin. Accounting Standards Bd. 2015). 130 Therefore, an accounting norm that determines which risks will require recording a liability – e.g., potential environmental damage caused by the firm's factories –actually determines for which risks shareholders will be liable and for which risks they will be released from responsibility because no liability is recorded and distributions to shareholders are not limited. Thus, if a risk is not covered by a liability matures, the firm can be left without resources due to dividends distribution. To the contrary, if the risk was covered by a liability, then distribution is limited, and the firm must maintain undistributed resources covering the risk. For a critique on GAAP treatment of contingent liabilities, See Mundstock, supra note 24 at 831-832. 131 Internal revenue code § 446(a) (I.R.C § 446(2012)) stipulates that “[t]axable income shall be computed under the method of accounting on the basis of which the taxpayer regularly computes his income in keeping his books,” meaning, according to the firm's existing accounting records, hence, GAAP. 132 Thor Power Tool Co. v. Comm'r, 439 U.S. 522 (1979). 133 In the Thor Power Tool case the Supreme Court ruled that due to differences between GAAP's objectives and the tax code's objectives, the IRS could modify a company's reported tax loss, even though the loss conforms to the company's financial accounting statements prepared in As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) paving the way for the Treasury to develop elaborate tax regulation, which substantially diminished the role GAAP plays in taxation. However, Thor Power Tool is the exception, not the rule. In most systems, the use of financial statements did not reach the “normative boiling point,” wherein the use of GAAP financial statements is replaced with alternative measures. Hence, the GAAP enjoys a substantive normative role in regulating these systems, at least until the advent of their own version of Thor Power Tool will appear. V. THE POLITICAL NATURE OF FINANCIAL ACCOUNTING The Jack and Jill metal scraps example (discussed in section II.C.) demonstrates how the financial expressions of complicated commercial transactions are not selfevident and should not be viewed as obvious. If accounting expressions are not neutral, and financial accounting's regulatory framework, i.e., the GAAP, contains a political bias,134 then by means of accounting, GAAP’s political substance filters down into the social order and affects not only preparers' conduct but also nonaccounting arrangements that utilize accounting parameters. Supposedly, if financial accounting has a hidden agenda to promote Jack by shaping accounting norms to express Jack’s action as more appealing than Jill’s identical actions, then Jack will be promoted at work, pay lower electricity bills, pay less taxes, and obtain cheaper credit than Jill, who is depicted in a less favorable light according to the rules created for maximizing Jack's financial expressions. Is accounting's consensual expression politically neutral? Does GAAP’s regulatory framework contain political biases? A. A New Look into Financial Accounting In providing comprehensive information regarding firms, GAAP, through the process of gathering a firm's information and expressing it in accounting terms, acts as a narrator, telling the story of the firm to financial statement users. Though it may not be evident at first glance, GAAP's depiction of the firm has a narrative manifest in a specific pre-determined point of view and voice used in depicting a firm's affairs. The specific perspective and specific voice used by the GAAP accordance with GAAP, hence making accounting expression subject to the tax system’s principles. See, e.g., Celia Whitaker, Bridging the Book-Tax Accounting Gap, 115 Yale L.J. 680, 688 (2005) (discussing Thor Power Tool’s “contribution” to maintenance of the book-tax accounting gap, however, while arguing for a system of near-total accounting conformity that uses financial income – as reported to investor – as the starting point for taxable income). Since the Thor Power Tool case, income computing for tax purposes according to GAAP is overridden whenever GAAP treatment, in the opinion of the Treasury, does not clearly reflect taxable income. See, id. at 685. 134 See, e.g. Gipper et al., supra note 17 at 531, Kothari et al. supra note 113 at 271-74 (discussing Ideology as a possible explanatory model for accounting standards-setting); Gipper et al., 537 (arguing that economic, institutional, and political factors play an important role in agendasetting at the FASB). As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) constitute the narrative of financial reporting, narrative that affects financial outcomes outside the accounting world. B. The GAAP Narrative A narrative is an account of events formed as part of the representation process that takes place in human discourse. That is to say, the world was not given to humans in pure form; instead, it is always mediated or represented to them.135 The Russian Formalists,136 and especially Viktor Shklovsky in his groundbreaking 1917 essay, Art as Technique, distinguishes between “fabula,” the raw material of a story, and “sujet,” the way a story is organized (its discourse and plot). The sujet represents the narrative used by the story-teller in the interpretation of the fabula – meaning the perspective and voice used in story-telling when pure story-facts are organized in a story and are presented to the audience.137 The accounting process, in which the firms’ affairs are expressed by accounting terms and concepts, creates a similar distinction between fabula and sujet. A firms’ activities – and the consequential data recorded in the firm's information systems – is not provided to statement users in its pure and raw form. Rather, it is mediated by GAAP and represented, i.e., expressed using the consensual accounting terminology to the users. In Shklovsky's terms, accounting's fabula are a firm's activities, whereas accounting's sujet is the financial statements prepared according to GAAP. Since the firm's events are regarded as primary and independent in relation to the discourse, the same course of events can constitute the basis of a number of different versions.138 What is being presented at the level of discourse is only one of several possible versions of events. The narrator can choose to depict the firm's activities and events from different perspectives or viewpoints.139 Recall Jill's deposit held by Jack – depending on the perspective chosen for depiction, it can be expressed as either an asset or a liability. C. GAAP's Perspective 135 Paul Cobley, Narratology, in THE JOHNS HOPKINS GUIDE TO LITERARY THEORY AND CRITICISM 677 (2nd ed. 2005). 136 Russian Formalists belong to a Russian school of literary criticism (named “Russian Formalism”) which emerged from the Russian Revolution with ideas about the independence of literature. Russian Formalists advocated a scientific method for studying literature, inter alia emphasizing research of the features that distinguish literature from other human endeavors, and the separation of “literature facts” from other facts – such as prior subjective preferences of the critic/reader – that affect the understanding of literature. 137 Representation, in general, is the production of meaning through language (Stuart Hall, The Work of Representation, in REPRESENTATION: CULTURAL REPRESENTATIONS AND SIGNIFYING PRACTICES 13, 16 (Stuart Hall ed., 1997)). 138 See Eva Broman, Narratological Focalization Models – a Critical Survey in Essays on Fiction and Perspective, in ESSAYS ON FICTION AND PERSPECTIVE 57, 57 (Göran Rossholm ed., 2004); BEAVER, supra note 8 at 16 ( “the selection of a financial reporting system is a social choice”). 139 Id. As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) What perspective is used by the GAAP in narrating a firms’ activities? The GAAP Conceptual Framework explicitly stipulates that: “Many existing and potential investors, lenders, and other creditors cannot require reporting entities to provide information directly to them and must rely on general purpose financial reports for much of the financial information they need. Consequently, they are the primary users to whom general purpose financial reports are directed.”140 Choosing investors as the primary users of financial reporting, and therefore the group whose information needs GAAP aims to fulfil, is done explicitly by the GAAP's regulatory framework, while other parties' information requirements (and perspectives) are shifted away by the GAAP.141 The Conceptual Framework continues: “Other parties, such as regulators and members of the public other than investors, lenders, and other creditors, also may find general purpose financial reports useful. However, those reports are not primarily directed to these other groups.”142 Hence, although different perspectives exist, the GAAP sees capital investors as the primary group of users for financial reporting, and therefore the group it aims to serve by providing them with the information they require. As a result, GAAP measurements are all made using the investor perspective:143 A gain for a firm's investors is expressed as a profit under GAAP, while a loss for its capital investors is expressed as an accounting expense.144 The perspective of investors and creditors, who benefit directly by dividends, principal and interest payments resulting from the firm's prospective net cash inflow, is very different from the perspective of those who benefit by developments other than increased prospective net cash inflow. Others, such as the firm's employees, who benefit from reduction of the firm's risk to its stability; or the general public, which benefits from a variety of different aspects besides 140 FASB, OBJECTIVE OF REPORTING, supra note 38 para. OB5. See VAN RIPER, supra note 3 at 21-22 (discussing some comment letters and testimonies at the FASB’s public hearing on this issue). 142 FASB, OBJECTIVE OF REPORTING, supra note 38 para. OB10. 143 See Bratton, supra note 24 at 7; Cunningham, supra note 52 at 62-63 (2008). 144 Although at the surface level of the narrative, GAAP adopts the perspective of “investors,” i.e., stockholders and creditors, practically speaking, on many occasions where stockholders' interests contradict the interest of creditors, GAAP favors stockholders exclusively. Early debt extinguishment, discussed above (supra notes 111-114 and accompanying text), is an example of such a scenario: Buyback of debt below its issue price is seen as a plausible and positive transaction by shareholders – the firm pays less than it owed and hence, more resources are left for shareholders (which can result in the distribution of more dividends) – but in the eyes of creditors, profits recorded due to buyback transactions are actually at their expense since they receive less than initially loaned to the company. GAAP expresses such transactions, which mainly serve stockholders' interests, as generating profits for the firm. It thus demonstrates a real inclination towards stockholders, one that incentivizes debt buyback transactions and improves the general accounting depiction, and as a result, the overall financial perception of firms that use financial resources in times of diminished market prices to transfer monetary and other resources from creditors to shareholders. Ironically, this includes improving such firms' future access – as compared to similar firms that utilize resources for uses other than debt buyback – to more credit resources. 141 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) prospective cash inflows, such as increased employment by the firm or increased tax payments by the firm. An example that shows how determinist GAAP's perspective is for the financial expression of a firm's affairs, their effect on the firm's books and management's incentives, as well as overall society145 is the accounting treatment of tax payments. This example illuminates once again the tremendous effects GAAP has on the social order as whole. The Profits Distribution Dimension of Tax Expenses Under GAAP, corporate income tax payments are recorded as an expense.146 It is represented in the firm's statements as a reduction in the entity's resources made in the course of generating profit. Nevertheless, behind the current consensus regarding the treatment of tax payments as an expense stands a long controversy involving accounting scholars and practitioners regarding the proper accounting treatment of tax payments. Should tax be seen as an incurred result of generating revenues, and hence expressed as an expense? Or, should tax payments be viewed as incurring ex-post revenue-generation and hence, as similar to other distributions of ex-post profits to parties entitled to such payments? At the heart of the debate147 stands a political controversy regarding the status of the state in modern capitalist society: Is the state a partner, entitled to a share of its citizens' success or, is the state only a supplier of citizen's needs? While the former perception supports seeing tax payments as ex-post profits distribution, the latter supports seeing payments as ex-ante expenses.148 The results of the position taken in this semi-political accounting controversy still affects contemporary attitudes toward taxation. Although the GAAP’s strict adherence to the perception of a company's capital investors does not provide answers to all of accounting's expression dilemmas (e.g., it does not provide a clear expression for Jill's deposit),149 it did provide a conclusive and straightforward answer to the controversy regarding the accounting expression of corporate tax payments. Since tax payments made to the state are at the expense of a company's capital investors, who otherwise – were no taxes due – would have 145 Cf. TINKER, supra note 101; but see Tony Tinker, Paper Prophets: An Autocritique, 33 BRITISH ACCT. REV. 77 (2001) (in which Tinker discusses some sizeable flaws in the flow of the argument in his book – Paper Prophets, id.). 146 See, e.g., ACCOUNTING FOR INCOME TAXES, Statement of Fin. Accounting Standards No. 109 (Fin. Accounting Standards Bd. 1992); International Accounting Standards Board, Preliminary Views on Financial Statement Presentation (Discussion Paper) §§ 3.56-3.62 (2008). 147 See Hugo Nurnberg, Conceptual Nature of the Corporate Income Tax, 36 ACCOUNTING HISTORIANS J. 31 (2009) for a discussion and summary of the different opinion. 148 Id. 149 Supra Section II.C. See, Bill Bergman, Accounting for Money: The Fair Value of Cash Assets and Deposit Liabilities, in RE-INVENTING REALITIES (Cheryl R. Lehman, Tony Tinker, Barbara Merino & Marilyn Neimark ed., 2004) (arguing that even cash assets, supposedly “easily” expressed by accounting, should not be reflected at face value under fair value accounting). As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) received a larger share of the company's profits, the payments are considered an expense.150 In essence, depicting tax payments as an expense is a political statement made by the GAAP. Tax is seen just like any other expense of the firm. The fact that tax money is used to improve society in different ways and is not a simple transfer of wealth from one party to another, but rather from one party towards the general good, is ignored by the GAAP. The influences of the political position taken by the GAAP are tremendous.151 One can only assume the results had the expenses/contribution debate been decided otherwise. Recording tax payments as an expense means that most important financial parameters according to which a company's – and its management’s – performance are measured, are negatively influenced by tax payments. Consequently, firms and managers are incentivized to reduce tax payments. Worse, firms that pay less tax (e.g., through aggressive tax planning) are rewarded with accounting expressions superior to those that pay more tax (on equal earnings).152 D. GAAP's Voice and the Loss of Information Perspective is only one element of the GAAP narrative; another element is the voice used by GAAP. In depicting and expressing a firm's activities, GAAP uses a univalent monetary voice and as a result, the firm’s actions are all depicted in monochromatic images that present only monetary information and omit many nonmonetary nuances. Due to the role accounting statements play in the discourse, many non-monetary nuances regarding the firm go undetected, and crucial information regarding firms’ actions is lost. Story parts (fabula) that directly affect future cash flow but also indirectly affect non-monetary aspects (such as employee welfare) are interpreted by accounting – and seen and evaluated by investors – according to their monetary impact alone, i.e., the revenues they are expected to contribute to the firm and its shareholders. Other fundamental, though nonmonetary, features of these represented story parts, e.g., the effect on employee welfare, are lost in the accounting representation. 150 Corporations that pay a high amount of taxes are less appealing to capital investors who are interested mainly in future cash flow distributed to them (exclusively). Therefore, information supplied in templates suitable for effective investing decisions record taxes as a negative transaction that occur ex-ante, before final profits attributed to a company's capital investors are generated (i.e., as an expense, and not as a distribution of profits). 151 Once firms are evaluated according to the perspective of capital investors, and not according to any other perspective, such as that of general society that benefits from taxes, then better performing firms are those that pay fewer taxes, and an accounting incentive is given for initiating tax planning that reduces tax liability, or at least allows tax payments to be postponed and therefore stay unrecognized as an expense by financial accounting (See e.g. Fadi Shaheen, The GAAP Lockout Effect and the Investment Behavior of Multinational Firms, 67 Tax L. Rev. 211 (2014)). Who bears the consequences of this specific accounting preference towards capital investors? Society as a whole. 152 E.g., the former's earning per share parameter will be higher than the latter's due to the recording of taxes as an ex-ante expense and not ex-post distribution. As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) Worse, although they differ substantially in their non-monetary effects, activities which are dissimilar are depicted and presented as similar solely because of their similar monetary effect on shareholders' interest. For example, when using a univalent monetary presentation, it does not matter if the firm sells juice in recyclable glass bottles or in non-biodegradable aluminum cans,153 sales are recorded, measured, and treated the same way – according to sales proceeds, which is the only important factor in evaluating the firm's future cash flow. The fact that one practice – using recyclable bottles – bears green qualities, while the other – using non-recyclable cans – is destructive to the environment, is obscured by accounting and omitted from the discourse. GAAP's narrative could have been different.154 Accounting could have used a multivalent voice to depict a firm's condition and activities, a pluralistic voice that would yield more information. However, more information might not provide advantageous service to all interested parties. Some sectors may benefit from blurring unflattering qualities about the firm's activities. For example pollution accounting measurements, made in the investor voice, only record and disclose monetary aspects of pollution,155 e.g., possible fines or legal suits that the firm is exposed to due to polluting activity. Other measurements, such as pollution type, location, and discomfort caused to the populace (odor, etc.) are not presented in the statements, nor are any monetary aspects to which the firm is not directly exposed either because of lack of environmental regulation, or the low chances of being caught. In addition, indirect collateral environmental damage, which is not regulated by the state, but regulated by the market, such as producing nonrecyclable commodities, is not disclosed to the public, and hence, avoids market regulation.156 The GAAP narrative adds a political dimension to financial accounting. The adherence to capital investors’ perspective in general, and that of stockholders, specifically,157 and the use of a univalent monetary voice that transfers information in patterns most usable for capital investors, both correlate superior accounting expressions with pro-investor activities and causes some parts of the firm's story to disappear from the final version of the firm's outcomes. In this manner, many features of a firm's practices are lost, perpetuating some negative qualities that go unnoticed by society.158 153 See Solomon, supra note 102 at 290. See, e.g., id.; TINKER, supra note 101. 155 See, e.g., Cecily A. Raiborn, Janet B. Butler & Marc F. Massoud, Environmental Reporting: Toward Enhanced Information Quality, 54 BUS. HORIZONS 425, 427-28 (2008) (discussing environmental disclosure requirements under GAAP) 156 The lack of non-monetary pollution disclosure is not due to lack of options. During the 1970s several suggestions for alternative non-monetary pollution disclosures were made by accounting professionals and academics, see, e.g., John T. Marlin, Accounting for Pollution, J. ACCOUNTANCY 41 (Feb. 1973). 157 See supra note 144. 158 See e.g. Dennis M. Patten, Did the GAO Get It Right? Another Look at Corporate Environmental Disclosure, 28 SOC. & ENVIROMENTAL ACCOUNTABILITY J. 21 (2008) (indicating that the depth of environmental cost disclosure appears to be limited in issuers’ 10‐Ks). 154 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) VI. COURTS’ (MIS) CONCEPTION OF FINANCIAL ACCOUNTING As mentioned, adopting the investor narrative results in GAAP’s correlation of positive accounting depictions with those that promote investor objectives in general, and those of stockholders, in particular. This correlation can have both a positive and a negative social outcome. Positive outcomes are incentives given by the GAAP to managers promoting stockholder interests. Correlating positive accounting depictions – inter alia used in measuring management's performance – with promoting the interests of investors mitigates some classic principal-agent problems that exist between investors and managers – who are motivated to act in their own best interests.159 Nevertheless, the correlation can also have negative outcomes. GAAP's effects are not limited to intra-firm relationships; the entire social order is affected by accounting practices and thus, by the accounting rules regulating it. As such, GAAP’s favorable inclination towards stockholders extends to social realms other than the shareholder-manager relationship, resulting in the political supremacy of investors over other parts of society expressed through many social aspects; e.g., access to resources such as credit.160 Another negative outcome is the projection of accounting's political perception onto social attitudes,161 e.g., society's perception of tax payments, which due to their accounting interpretation as an expense, are perceived in all social arrangements based on accounting outcomes as a negative economic phenomenon, which must be minimized. The legal perception of financial accounting, as presented in court rulings, seems not to grasp the true nature of financial accounting and is held captive by a misconception that sees financial accounting and GAAP as socially neutral. The three seminal accounting-related court cases discussed in this section demonstrate the legal misperception of financial accounting and how this misperception has evolved into a perception that releases GAAP promulgators from bearing responsibility for social outcomes of their actions and from a material judicial review of the standards. A. Appalachian Power Co. v. AICPA 162 The Appalachian Power Co. case, adjudicated in 1959, is the first (documented)163 adjudication of accounting standards. In this case, three interrelated electric utility companies (Appalachians) sought a judgment enjoining 159 Cf. Adolf A. Berle and Gardiner Means, THE MODERN CORPORATION AND PRIVATE PROPERTY (1932). 160 See supra note 144. 161 Hines, supra note 100. 162 Appalachian Power Co. v. American Inst. of Certified Pub. Acct., 268 F.2d 844 (2d Cir.) (per curiam), cert. denied, 361 U.S. 887 (1959). 163 According to both LexisNexis and Westlaw data sources. As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) the AICPA from circulating to its members, or to any members of the accountancy profession, a letter from the AICPA Committee on Accounting Procedure (CAP)164 specifying AICPA’s opinion regarding the accounting treatment of “deferred taxes.” Deferred taxes are surpluses created on an entity's books due to temporary differences between tax liabilities calculated according to book numbers, and actual taxes paid (calculated according to the tax code).165 The CAP held that deferred taxes must be recorded as a liability in the books and under no circumstances should be recorded as part of the entity's capital.166 The Appalachians recorded tax deferrals as part of company capital, and not as a liability.167 Since the Opinion contradicted Appalachians' existing accounting treatment for deferred tax, the companies sought to delay its distribution, arguing that the accounting treatment promulgated by the CAP contradicted existing accounting practice, and would cause their statements to lose credibility among other market parties affected by CAP opinions.168 As an aside, it is worth noting that CAP's view of deferred taxes as a liability of the company, rather than as part of its capital, corresponds to the perception of deferred taxes as payments which the company (and therefore its stockholders) is expected to pay in the future. Since these payments are due to others than the firm's capital investors, under an investor perspective, deferred tax cannot be recorded as part of a company's capital, which represents the capital investors’ equity share in the entity. However, if the firm is depicted using a different perspective, e.g., such that considers the state as a legitimate shareholder in the firm, then payments can be recorded as part of a firm's capital – representing the state's share in the entity's equity. Interestingly, the question regarding the nature of the accounting treatment of taxes – although heavily discussed by professionals at the time169 – was not contemplated by the court in the Appalachian Power Co. case. After Appalachians' request for an injunction was denied at first instance, the Court of Appeals for the Second Circuit affirmed the first instance judgment while also explicitly rejecting Appalachians' thesis for care duties owed to them by the 164 See supra note 77 and accompanying text. Many factors can create such differences, among them are past losses carried forward that reduce current tax liability, or special tax credits which increase current deductions at the expense of later decreases in deductions, e.g., accelerated depreciation. 166 Therefore, any existing deferred taxes recorded in an entity's capital must be reclassified, and presented as a liability. 167 CAP's opinion was intended to create a consensual accounting treatment of deferred taxes; prior to the letter, no uniformity existed among preparers. 168 Memorandum on behalf of Appellees in Opposition to Appellants' Motion for Injunction at 14, Appalachian Power Co. v. American Inst. of Certified Pub. Acct., 268 F.2d 844 (2d Cir.) (1959) http://www.sechistorical.org/collection/papers/1950/1959_0501_AppalachianAICPAAppeals.pdf. 169 See Nurnberg, supra note 147. 165 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) AICPA due to its public role as an accounting standards promulgator. The court stated: We think the courts may not dictate or control the procedures by which a private organization expresses its honestly held views. Defendants' action involves no breach of duty owed by them to the plaintiffs. On the contrary every professional body accepts a public obligation for unfettered expression of views and loses all rights to professional consideration, as well as all utility, if its views are controlled by other criteria than the intellectual conclusions of the persons acting.170 The court's ruling in the case clearly demonstrates a reluctance to intervene in the promulgation of accounting standards. The broad social implications that resulted from the restatements of tens of millions of dollars of company capital171 are ignored, as is the effect the restatement had on rate determination172 and stability of the utility companies. Alternatively, the court focuses on a narrow intention test, argued to exclusively justify a legal intervention in standards promulgation: “Absent a showing of actual malice or its equivalent the courts would be making a great mistake, contrary indeed to their own ideals and professions, if they assumed to restrict and denigrate this widely recognized and assumed professional duty [of accounting standards promulgators].”173 The accounting expression was seen by the court in the case as an isolated factor examined by the court irrespective of any external social implications. Moreover, accounting standards promulgation was seen as a bias-free process, guided solely by an intellectual spirit which should not be deflected by external legal duties that would only limit pure professional considerations. Per the courts in the case, the GAAP is perceived to be almost scientific; resulting from “the intellectual conclusions of the persons acting,”174 and neither is political agenda present in the process,175 nor are political biases created in financial accounting. B. Credit Union National Association Inc. v. AICPA176 The legal conception represented in the Appalachian Power Co. case was challenged nearly thirty years later, in the Credit Union National Association Inc. case, where plaintiffs argued against an accounting practice concerning credit union 170 268 F.2d at 845. Supra note 168. 172 See, e.g. Jill Hooks & Stewart Ross, The Changing Role of Accounting: From Consumers to Shareholders, 29 CRITICAL PERSP. ON ACCT. 86 (2015) (examining the role accounting practices played in the redistribution of wealth among existing consumers and new shareholders when a New Zealand electricity entity was reorganized from a co-operative to a shares-for-profit corporation). 173 268 F.2d at 845. 174 Id. 175 See in general, Ross L. Watts and Jerold L. Zimmerman, Positive Accounting Theory: A Ten Year Perspective, 65 ACCT. REV. 131 (1990); Ross L. Watts and Jerold L. Zimmerman, Towards a Positive Theory of the Determination of Accounting Standards, 53 ACCT. REV. 112 (1978). 176 Credit Union Nat. Ass'n, Inc. v. American Inst. of Certified Pub. Acct., 832 F.2d 104 (7th Cir. 1987). 171 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) institutions. While in the Appalachian case, no argument was made against promulgated standards being false or fraudulent and therefore, arguably, not passing the narrow legal test for intervention,177 in the Credit Union case, the plaintiffs’ arguments were focused on factual errors in the accounting practice promulgated by the AICPA for credit unions, therefore, supposedly justifying court intervention according to the legal test presented in the Appalachian case. Unlike deposits in commercial banks, which only grant depositors the right to the cash deposited and interest payments, a deposit in a credit union makes the depositor a member of the union. Among other rights, it grants the depositor the right to vote in union assemblies, to receive dividends and to share in remaining profits in instances of union liquidation. These additional rights characterize deposits in credit unions with equity-like features. Credit unions have therefore presented client deposits as part of their equity, rather than as liabilities. The latter presentation has been used by commercial banks, which depict client deposits as liabilities in their financial statements.178 As mentioned above,179 in order to help accountants prepare reports in the absence of formal statements of GAAP, the AICPA issues pronouncements stating its view on such non-treated accounting matters. In 1986, the AICPA published a manual titled “Audits of Credit Unions,” in which the Institute instructed that no matter how clients' deposits are denominated between a credit union and its member-investors, deposits should be presented as liabilities in the credit union's financial statements. Presenting deposits as liabilities rather than part of union's capital had a substantive effect on credit unions and, inter alia, their ability to fulfil regulatory minimal capital requirements. Therefore, the Credit Union National Association filed a suit against AICPA, arguing that the Institute’s characterization of shareaccounts in credit unions as liabilities was incorrect.180 Again, as an aside, it is worth noting that although the formal question presented in the case concerned the most appropriate accounting definition for credit union deposits, the real question underlying the case concerned society’s attitude towards not-for-profit banks, and the social empowerment of the not-for-profit banking community, inter-alia, through financial depictions. As the discussion in previous sections implies, accounting's depiction of deposits as a liability or equity goes beyond simple accounting classifications. Recognizing member deposits as equity means that clients in credit unions are perceived, socially, as different from clients of commercial banks. Depicting financial institutions from a social perspective distinguishes between the depiction of deposits in credit unions and deposits in commercial banks. While credit unions are financial cooperatives operated for the 177 Supra note 173 and accompanying text. 832 F.2d at 105. 179 See text following note 90 supra. 180 Inter alia, causing the financial statements to misrepresent the true status of share deposits in credit unions and hence in violation of the common law in Wisconsin (832 F.2d at 105). 178 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) purpose of promoting thrift to its members (who also control it) via supply of credit at competitive rates, commercial banks lack such features. If we care about these qualities and want statement users to be aware of them when making decisions regarding the firm, then financial statements should reflect them. Credit unions expressed these qualities inter alia through capitalizing part of the deposit as equity – representing rights given to depositors. Nevertheless, depicting credit union deposits from a capital investor’s perspective, interested only in prospective cash inflow, results in deposits being recorded as mere debts which the entity is expected to pay, in a fashion similar to commercial banks.181 In affirming the district court's dismissal, the United States Court of Appeals for the Seventh Circuit based its reasoning on a perception that sees accounting standards as definitional rules, and as such, the credit unions’ complaint against the AICPA is compared by the court to a baseless complaint the credit union might lodge against The Oxford Dictionary concerning the definition of the term “debt”: The Guide does not say that share deposits ‘are’ liabilities, as if words had meanings bestowed by natural law. The Guide states an axiom rather than a conclusion. It simply makes financial reports more consistent, and thus easier to understand. […] The Credit Union National Association might as well sue Oxford University for defining ‘debt’ the same way the AICPA does – as ‘that which is owed or due;’ anything . . . which one person is under obligation to pay or render to another.182 The court then summarizes: “Arguments may be made for or against any particular classification of such a hybrid instrument. The NCUA[183] may prescribe a treatment. The judicial branch of government should stand clear of definitional disputes.” Both the court's perception of GAAP as definitional rules (as expressed in the Credit Union National Association Inc. case) and as being the product of pure intellectual efforts lacking any political content or substantive social impact (as expressed in the Appalachian Power Co. case) established zero intervention by the court in accounting issues. The court’s (mis) apprehension of accounting standards’ neutrality and the derived non-adjudication of the GAAP was reinforced and further developed in a third case, from the Connecticut Supreme Court, where investors – supposedly GAAP's declared primary user group184 – argued against accounting standards promulgated by the AICPA, and against AICPA itself, arguing the Institute breached its duty of care owed to them. C. Waters v. Autuori185 181 Similar to the Appalachian Power Co. case, the question regarding the nature of the accounting treatment of credit union deposits was not contemplated by the court. 182 832 F.2d at 107-108. 183 National Credit Union Administration - the federal agency with authority over credit unions. 184 Supra note 140. 185 Waters v. Autuori, 676 A.2d 357 (Conn. 1996). As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) In Waters v. Autuori, legal discourse moved from contemplating the nature of standards to discussing the direct social consequences of their promulgation when a group of investors brought an action against the AICPA (and others) seeking damages for AICPA's negligent promulgation of professional accounting standards. In this case, investors explicitly claimed that the AICPA owed a duty of care to them, as primary users who relied on statements prepared according to accounting standards promulgated by the AICPA. Arguing the Institute should be held responsible for a loss incurred to them due to an investment made while relying on financial statements prepared according to GAAP.186 The case eventually reached the Supreme Court of Connecticut, which relieved the Institute of any such duty of care.187 In affirming the motion to strike and granting partial judgment in favor of the Institute, the Supreme Court of Connecticut adopted the perception expressed earlier in the Appalachian Power Co. and the Credit Union National Association Inc. cases,188 according to which accounting standards lack any independent effects and are bias-free, and further expanded that perception. According to the Connecticut Supreme Court, it all depends on the accountant, and the way he or she implements GAAP requirements. Standards themselves are neutral. The Connecticut Supreme Court stated: The standards provide a framework for what ultimately is the opinion of the certified public accountant. That opinion is formulated and expressed in light of the accountant's professional judgment and discretion. Any liability arising from the standards therefore, would be premised on an accountant's application of AICPA standards in his or her exercise of professional judgment rather than on the standards themselves.189 Per the Connecticut Supreme Court,190 financial accounting standards themselves are not embodied with any independent social impact. Social outcomes, if such do exist, are attributed solely to the accountants that follow the standards. In consequence, promulgating accounting standards does not yield any special social 186 The exact legal question presented in the case concerned whether the promulgation of professional accounting standards is sufficient, by itself, to impose upon the promulgating professional organization a duty of care to a third party who relies on the opinion of a certified public accountant claiming to have followed those standards. In suing the AICPA, investors claimed that, while following AICPA standards, the partnership's accountant (“Kostin”) prepared unreasonable financial forecasts. By allowing such forecasts to be made under existing standards, the AICPA had been promulgating accounting standards in a negligent manner (676 A.2d at 359). 187 “[T]he AICPA, as a matter of law, did not owe to the plaintiff a duty of care based solely on its promulgation of professional accounting standards.” (676 A.2d at 365). 188 676 A.2d at 362. 189 676 A.2d at 363. 190 However, not all the justices agreed accounting standards and their promulgators to be held ex-jure. Justice Berdon of the Connecticut Supreme Court dissented, arguing that the AICPA owes a duty of care to investors and other individuals who are effected by accounting standards. 676 A.2d at 368. As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) responsibilities or duties, not even when affected users are investors themselves, a user group identified by GAAP as its primary users. The immunity endowed by the court to accounting standard-promulgation, and the misconception underlying it, further stands out in light of the prevailing legal attitude that views the conduct of other, non-accounting, private standardpromulgators as generally exposed to legal scrutiny in cases that involve tort liability:191 Standards created by private voluntary organizations, such as blood bank protocols or even schedules for starting football practice – even though promulgated in good-faith and without an underlying political agenda192 – have been re-examined by juries in adjudications initiated by those injured or damaged by services conforming to such standards.193 However, by following Appalachian Power Co. v. AICPA and Credit Union National Association Inc. v. AICPA,194 the Waters v. Autuori case makes accounting standards promulgation and promulgators practically immune to tort liability and legal scrutiny in general. VII. SEC’S (REVISED) GLOBAL ACCOUNTING VISION: A POSSIBLE GAME-CHANGER? A recent SEC proposal to allow IFRS-based disclosures,195 as supplemental to those of GAAP, might provide an answer to the existing hegemony of politicized accounting standards that seem to enjoy protected status. Enriching accounting discourse with additional non-GAAP-based financial results has the potential to curtail GAAP hegemony over the discourse, broaden the perspectives adopted and affect the conduct of existing GAAP promulgators. For a number of years the SEC has been promoting a global accounting vision:196 A single set of high-quality, globally accepted accounting standards to be used worldwide, including in the U.S.197 - so far, though, without much 191 See Heidt, supra note 19; see also Ochoa, supra note 5 at 506 (indicating that in contrast to several other standard setters, like the EPA, the FTC, and the FCC, the work of FASB has been mostly insulated from challenges). 192 E.g., id. at 1255 (discussing American Association of Blood Banks’ standards), 1263 (discussing “lack of dominance” in standards establishment as a factor that can contribute to an exemption from tort-liability). 193 Id. at 1237; compare Richard C. Ausness, The Disorderly Conduct of Words: Civil Liability for Injuries Caused by the Dissemination of False or Inaccurate Information, 65 S.C. L. REV. 131, 182-86 (2013) (discussing courts’ ruling on defective design standards promulgated for professional association' members). 194 Supra note [“676 A.2d at 362”]. 195 IFRS are international accounting standards, used for reporting financial results by many countries around the world (see supra note 25). 196 Roadmap for the Potential Use of Financial Statements Prepared in Accordance with International Financial Reporting Standards by U.S. Issuers Release No. 33–8982, 73 Fed. Reg. 70816 (Nov. 21, 2008). 197 See Cunningham, supra note 52, William W. Bratton, Heedless Globalism: The SEC’s Roadmap to Accounting Convergence, 79 U. CIN. L. REV 471 (2010) and Neal F. Newman, The U.S. Move to International Accounting Standards – A Matter of Cultural Discord – How do we Reconcile?, 39 U. MEM. L. REV. 835 (2009) (all critically discussing the vision, arguing against the As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) success.198 The new SEC’s “regulatory maneuver” – mentioned in recent speeches by SEC leadership199 – allows domestic issuers to voluntarily disclose supplemental IFRS-based financial results in addition to those of GAAP. Although IFRS and GAAP carry many shared characteristics, e.g., strong orientation towards information suitable for investors200 including excessive use of monetary-based disclosures,201 IFRS carries some other qualities202 that present a broader perspective than those of investors alone.203 To take one example, when it comes to recognizing liabilities and de facto limiting shareholder distributions, IFRS is in fact more “orthodox” than GAAP, i.e., inclined towards shareholders other than stockholders. Under IFRS it is sufficient that the realization-risk of a company’s hazardous actions meets the threshold of more likely than not to occur (>50%) for a financial liability to result;204 i.e., the probability required for hazardous activity to cause a firm's profits to become non-distributable is 51%.205 In contrast, under GAAP, the parallel threshold is likely to occur,206 a probability higher than more likely than not, treated as approximately 80%.207 Hence, the tendency to lock-in shareholders’ profits is higher under IFRS.208 IFRS’s unique accounting flavor is due to a number of reasons. Historically speaking, international accounting was initially designed to agree with various existing national accounting systems209; hence, it adopted some of those systems’ use of IFRS by U.S. firms); compare Martin Gelter & Zehra G. Kavame Eroglu, Whose Trojan Horse? The Dynamic of Resistance Against IFRS, 36 U. PA. J. INT’L L. 89 (2014) (arguing that introducing IFRS in the U.S. should be considerably easier that it was in the E.U., inter alia because of the shared orientation towards investors). 198 Remarks before the 2014 AICPA National Conference, supra note 24. 199 Supra note 27. 200 Martin Gelter & Zehra G. Kavame Eroglu, supra note 197. 201 See e.g. MARY E. BARTH, RESEARCH, STANDARD SETTING, AND GLOBAL FINANCIAL REPORTING, 11-13 (2007). 202 See e.g. Bratton, supra note 197 (analyzing differences in accounting treatments under GAAP and IFRS while also highlighting the two systems' different normative roots). 203 See Cunningham, supra note 52 at 63; Mundstock, supra note 24 at 841; compare, Luzi Hail, Christian Leuz, & Peter Wysocki, Global Accounting Convergence and the Potential Adoption of IFRS by the U.S. (Part I): Conceptual Underpinnings and Economic Analysis, 24 ACCT. HORIZONS 355, passim (2010) (arguing that no major incompatibilities exist between IFRS and other elements of the U.S. reporting environment and institutional framework); Martin Gelter & Zehra G. Kavame Eroglu, supra note 197. 204 PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS, International Accounting Standard No. 37, §23 (Int’l Accounting Standards Bd. 1998). 205 See supra text accompanying notes 129-130. 206 ACCOUNTING STANDARDS CODIFICATION, Topic 450 Contingencies, para. 450-20-20, 45020-25-2 (Fin. Accounting Standards Bd. 2015). 207 See Recognition of Contingent Losses/Provisions, IASPLUS.COM, http://www.iasplus.com/en-us/standards/ifrs-usgaap/contingencies (last visited July 3, 2016) (elaborating the difference between US-GAAP and IFRS contingencies recognition). 208 See supra text accompanying notes 129-130. 209 Therefore included at the time multiple alternative accounting treatments – to conform to different countries’ existing accounting practice. As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) other-than-investor narratives.210 Another reason is the strong dependency of IFRS on European Union recognition: One of the main sources of legitimacy for the IFRS is the fact that its standards are adopted by the European Commission and binds all EU member states.211 As a legal restriction set in the European IAS Regulation,212 IFRS standards can only be adopted by the Commission if they are “conducive to overall European public good.”213 As a result, IFRS is effected by broader considerations than those of investors alone.214 Although IFRS is not expected to revolutionize domestic accounting discourse altogether,215 the univalent tone currently governing the discourse will probably be affected. First, allowing other disclosures that “compete” with GAAP numbers can affect GAAP impact on statements users216 and thus curtail its hegemony by drawing attention to alternative IFRS-based results which present other qualities.217 Second, it can cause GAAP promulgators themselves, perhaps in an attempt to regain lost influence, to enrich GAAP disclosures so as to include accounting flavors in addition to those currently prevailing. All in all, enriching U.S. accounting discourse with additional IFRS disclosures has the potential to affect the current narrative dominating U.S. accounting discourse and broaden the interests promoted by the standards regulating the 210 E.g., the German accounting system is characterized by strong creditor and tax narratives. See Gipper et al., supra note 17 at 559 (mentioning IASB amendment of IAS 39 - allowing retroactive reclassification of financial instruments - made only to avoid imminent action by the EU that would have carved out the relevant portion of IAS 39, something the IASB viewed as potentially damaging its status as a global accounting standard-setter). 212 EP and Council Regulation 1606/2002, OJ 2002 L243/1 [IAS Regulation]. 213 Article 3(2) of IAS Regulation. 214 On June 7 2016, following discussions of Economics and Finance Ministers of the Member States (ECOFIN) and in light of a special report titled Should IFRS Standards be more "European"?, the European Parliament adopted a resolution which calls the Commission to comply with the expansion of the ‘public good’ criterion (as recommended in the report), and stipulates the following as part of its reasoning: “[W]hereas the IFRS and ISA can be understood as a public good, should not therefore endanger financial stability or hinder the economic development of the Union and should serve the common good and not only the interests of investors, lenders and creditors.” (Resolution International Accounting Standards (IAS) evaluation and the activities of the International Financial Reporting Standards (IFRS) Foundation, the European Financial Reporting Advisory Group (EFRAG) and the Public Interest Oversight Board (PIOB) (yet unpublished) provisional edition available at: http://www.europarl.europa.eu/sides/getDoc.do?pubRef=//EP//TEXT+TA+P8-TA-2016-0248+0+DOC+XML+V0//EN&language=EN (last visited July 3, 2016). 215 See Ray Ball, Market and Political/Regulatory Perspectives on the Recent Accounting Scandals, 47 J. ACCT. RESEARCH 277, 312 (2009) (arguing in general that even if IFRS were to be implemented in the U.S., the SEC would pay only lip service to the change and would maintain the current system preferences). 216 See Kothari et al. supra note 113 (arguing that competition, rather than convergence, between the FASB/US-GAAP and the IASB/IFRS would allow GAAP to better respond to market forces). 217 See also Mundstock, supra note 24 at 844-45 (assuming – while discussing an option to allow domestic firms to use IFRS in lieu of GAAP – that IFRS standards would be more appealing for companies, leading eventually to a reduced role of private standard-setting in accounting). 211 As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) discourse.218 As a result, it can constitute a competition-driven, market-based solution to existing biases of the GAAP. VIII. SUMMARY AND CONCLUSIONS Financial accounting is the language of the business world, and the GAAP provides its terminology. The dictionary-like use of GAAP terms in business discourse conveys a conception of GAAP as neutral and bias-free. This article challenges such conceptions regarding the GAAP. Through the discussion of two distinct social effects associated with financial accounting, the downstream social effect, which causes preparers to change their behavior according to accounting standards, and upstream social effects, which affect the functioning and control of non-accounting systems, this article explains GAAP's substantive social effects on corporate behavior and on the function of many social, political and financial systems that utilize accounting parameters. This article then reveals how by exclusively focusing on changes in prospective net cash inflow and its expression using a univalent monetary voice, the GAAP implies a biased agenda that prefers the investor perspective over counter perspectives, thereby creating a biased financial perception of reality, one that subordinates the social order entirely to investor objectives.219 The article, however, goes beyond merely exposing the true (and political) nature of financial accounting. It discusses the legal perception of accounting, how it is mistakenly perceived, and the resultant social and legal implications. Adjudications in three prominent court cases concerning accounting standards promulgation are reviewed, revealing the courts’ misconceptions regarding the GAAP and its results. The absence of GAAP’s political characteristics and substantive effects on society from the court’s legal discourse, results in a lack of judicial review over the establishment of the GAAP or the content of the standards. A small number of private organizations continue to possess unbridled power to establish accounting norms while, at the same time, not being subject to any care or social duty towards the users of the standards or others affected by them. Revealing GAAP's true political nature and tremendous effects on society might affect future adjudications of accounting issues, possibly “breaking the spell” that currently protects the GAAP and its promulgators from material legal scrutiny. 218 See also, Luzi Hail, Christian Leuz, & Peter Wysocki, Global Accounting Convergence and the Potential Adoption of IFRS by the U.S. (Part I): Conceptual Underpinnings and Economic Analysis, 24 ACCT. HORIZONS 355, 382, 388 (2010) (assessing that certain re-distributional effects across firms and service providers are expected from switching to IFRS reporting in the U.S.). 219 Economics-based accounting literature premised GAAP theory on the idea that the objective of financial statements, and hence the GAAP, is to facilitate efficient capital allocation in the economy, and that such efficient capital allocation requires the use of investors’ narrative, see, e.g., Kothari et al. supra note 113 (inter alia, summarizes the economic arguments in the literature that explain why GAAP is likely to be shaped by certain stakeholder demands, and that investor-based information is correlated with the information that facilitates efficient allocation of capital in an economy). As of Sep. 9, 2016; Israel Klein, The Gap in the Perception of the GAAP, 54 AM. BUS. L. J. (forthcoming 2017) Meanwhile, this article also draws attention to a possible solution found in a recent SEC proposal to allow issuers to disclose additional unconsolidated IFRS-based financial results. Such IFRS-based disclosure implements accounting flavors that differ from the prevailing GAAP, and therefore are expected to broaden the accounting narrative beyond the exclusive and absolute use of the investor perspective. However, the chances that the SEC proposal will mature into effective regulation depends on market willingness and acceptance of such enrichment to the existing accounting discourse. This is also the case as far as the extent of the new IFRS-based disclosures’ social outcomes are concerned, and whether they will affect financial accounting’s upstream and downstream effects, etc. IFRS-based disclosures might curtail GAAP hegemony over the discourse, and might broaden the perspective effectively included in the accounting narrative, if, and only if, implemented by issuers and evaluated as important by the market and other systems that rely on accounting parameters. Exposing existing GAAP biases and the possible solution additional disclosure presents, as done in this article, might facilitate these process.