One Set of Books, or Two?

ill Hambrecht discusses why companies keep two sets of books, and why they shouldn’t. WR Hambrecht’s OpenIPO^® is leveling the playing field among investors, issuers and the investment banks and has been called one othe few disruptive innovations in modern finance. In addition to WR Hambrecht + Co, Bill co-manages Hambrecht Ventures I focused on disruptive technologies.

If you would like more information on this series of conversations with Bill, contact Peter Morrissey at 415-551-8613.

My response to these scandals is that the SEC should eliminate GAAP.

No, not at all.  The companies already keep a detailed set of accounting records for the IRS – the SEC should require that public companies use their tax books to report their results to the public.

The tax code has a discipline that GAAP lacks: the IRS aggressively enforces its rules through fines, civil and criminal liability. Some larger companies even have a full-time IRS auditor on site every day. GAAP lacks the teeth that the government has given the tax code.

Also, having a single set of rules makes it harder to find loopholes. According to the Treasury Department, a principal characteristic of a tax shelter is the exploitation of inconsistencies between GAAP and tax accounting.  I believe that the same is true for financial reporting scandals. Each of the companies you mentioned exploited the differences between tax and GAAP rules. Enron paid no income tax in four of the five years before it went bankrupt while at the same time racking up large GAAP profits and Refco’s tax accountants, Ernst & Young, refused to work on the company’s 2004 tax returns.

Forcing public companies to use one and only one set of financial reporting rules reduces the potential for abuse and would reduce costs for both companies and regulators.  Right now lawyers and accountants constantly test the boundaries of GAAP and the tax code: they push as hard as they can to inflate income under GAAP and reduce it under the tax code.  We need a whole army of IRS auditors to push back to make sure income isn’t underreported on the tax books and another army of SEC regulators and CPAs to police the GAAP books from over reporting. It is a never ending battle: every time the regulators close one loophole, the lawyers scurry off to find another one. 

A unified set of books would reduce the incentives to push regulatory boundaries.  In cases where financial reporting rules give the CFO a choice on how to report income or expenses, he or she would have to choose between disappointing investors or paying more to the tax man. 

As a young banker, I was taught to ask for the company’s tax returns if I wanted to understand the real numbers. My boss noted that if the company was willing to pay 30 cents for every dollar they earned, it was real profit.  That’s why almost every bank reviews a company’s tax returns before approving a loan.

Have you ever read some of the GAAP rules?  They are just as complex as most parts of the tax code and often inconsistent with each other!

By only having one set of accounting rules we would immediately reduce the complexity of modern financial reporting by 50%.  In addition, the remaining rules would probably be easier to understand and apply.

Much of the complexity of modern financial reporting rules comes from regulators and legislators trying to close loopholes and then patching up new problems created by the rules implemented to close the loopholes and then fixing the errors in those patches. Sarbanes-Oxley is the perfect example of that: trying to improve financial reporting with new regulations that create more complexity and cost and their own set of problems.

Simpler regulations will reduce the costs of compliance and also make it easier for financial analysts and investors to interpret financial reports. The more complex the definition of net profit is, the harder it is to understand and the less meaningful it is to anyone other than a tax or accounting specialist.

Reported earning might be lower than they are now, but they would reflect the same underlying economic value of the company, so I don’t think that stock prices would decline, in fact I believe they would increase for many companies.

Investors are trying to value the enterprise as a whole and poorly reported earnings, or puffed up earnings reports, make it harder to determine the true value of the company.  A clearer set of financial reports would decrease the risks for investors and make them more confident of the underlying value of the company. That increased confidence would probably increase stock prices.

Of course, if a company has been using accounting tricks to puff up GAAP earnings and its stock price, investors might realize that once they shift to tax reporting and the market value of the company would decline to its true economic worth.

Exactly!