Solomons: Making Accounting Policy:

The comment on the dust cover raises eyebrows: Duane R Kullberg, managing partner and CEO of Arthur Anderson and Co. is quoted as saying "[the] focus on the deficiencies of our historical cost framework is right on point...

Making Accounting Policy goes beyond a cogent, thoughtful analysis of the problem; it provides a logical and compelling solution."

The "problem" was that company balance sheets showed what had happened. "The accounting policies that companies follow in preparing their financial statements have assumed critical importance in recent years. The way that revenues and expenditures, assets and liabilities are treated can make an enormous difference in the way a firm's performance and its financial position are judged by stockholders, the financial community, the regulatory agencies and the public," writes David Solomons in his blurb for "Making Accounting Policy: the quest for credibility in financial reporting" (1986).

Despite the title, the book seemingly makes out a case for exactly the sort of accounting that would later mutate into the smoke and mirrors that fueled the dot-com boom and facilitate the mess that became Enron and others.

It would be wrong to lay the blame for all that at Solomons' door but not only did he promote the "standards" in this book but also played a major role in the USA's Financial Standards Accounting Board having been on the committee that formed it and a member of it from 1982-1985. This book, written in 1986 may therefore be taken to have considerable authority.

In his preface, Solomons says "the failure or near failure of important financial institutions has cast doubt on the integrity of financial reporting and on the accounting policies that underlie accounting statements."

He says that accounting should set out "the economic reality" of but business. He says of the Board "I make no secret of my preference for a system based on current, not past costs. In my view, there is an urgent need for change," and "at the present time, those who, like me, advocate a model based on current values are in a minority."Unfortunately, the question of current values was, even as the book was published, being stretched. Following an analysis of various alternative types of current cost accounting, Solomons writes "the preferred alternative, without much doubt, is current cost constant purchasing power accounting." So, what it is? It is a measure of value with regard to predictive purchasing power to take account of anticipated inflation. In short, it already creating a fiction in the accounts. It restates appreciating non-monetary assets at their enhanced value: whilst one can see some merit in this argument for, say, property it is in the supposed value of "goodwill" or brand values that the opportunity arises for hugely overstated figures in order to shore up balance sheets.

Solomons sees "creative accounting" as a bad thing when done for the wrong reasons but a benefit when done for the right reasons.

It is hard to see where there is a right reason. The entire thesis of the work is to create balance sheets that support confidence from investors and lenders. It is difficult to see why there is a need to have an accounting standard that says anything more than "this is what we brought in, this is what we spent, this is what it is worth in a fire sale." Anything more than that is, surely, creative and misleading. Indeed, it substitutes opinion for fact, which is not, so far as public perception is concerned, what auditing is all about. Or have we missed the point?

Solomons does not approve of all measures later widely adopted. Of off balance sheet financing he says "the liabilities shown in a balance sheet may be substantially less than a company's true obligations to outsiders." He also mentions, particularly, a system approved within GAAP: that of the "non-consolidated subsidiary." This is where a majority owned company in a business which is quite different from that of its parent, does not form part of the consolidated accounts: "The result of not consolidating a finance company's balance sheet with that of its (manufacturing parent) is generally to maintain a lower debt to equity ratio in what is left of the consolidated balance sheet than if the finance company had been included."

In "why measure income?" Solomons appears to be promoting the inclusion of all income items as a basis of establishing the health of a company: this may be the germ that grew into the idea that a company should be valued on "revenues" not profits, and which led to the massive overstating of values of companies prior to the dot.com collapse.

But perhaps the nearest aspect to the Enron et al debacle is foreshadowed by the discussion on the treatment of costs for exploration in oil and gas. Explo is a seriously expensive business. If all costs are shown on a current cost basis, it would have a massive impact on the balance sheet. So two schools of thought developed: full cost (in which the money spent is carried forward against future revenues) and "successful efforts costing" in which acquisition costs of properties (therefore assets) were shown in the balance sheet but unsuccessful (or incomplete) explo was charged as expenses. Those using full cost argued that successful efforts costing would mean showing reduced profits, so making capital raising more difficult.

And so, here is the nub of the argument. If telling the truth ("this is what we spent, this is what we earned") makes a business unattractive to an investor, then surely to tell him anything else to induce him to make that investment is a fraud.

On balance, Solomons is not the root cause of Enron and others, but he is a stepping stone on the way.

Solomons himself recommends reading Arthur Anderson's "Objectives of financial statements for business enterprises" (1984). That may yet prove to be another milestone on the journey to Enron. If any copies escaped the shredder. After all, at page 223, Solomons talks about "the big eight " accounting firms.

And this in a book published in 1986

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