Graduation Day at the Sunshine Pre-school is always a raucous event.

The ceremony consists of dressing up a large cadre of four and five year olds and requiring them to sing songs while simultaneously making a Herculean effort to keep them from the dessert table set up in the back of the room.

Rushing in 5 minutes or so late, I took my usual place by the window, as I had when my daughter went through the ritual.

After chatting with “The Dads” for a few minutes, the inevitable question arrived, “So what do you do for a living?”

Rather than tell them that I am the leader of dynamic firm that helps companies reduce risk, report better and manage their cash, I stupidly replied, “I’m an accountant.”

The floodgates instantly sprang open and I nearly drowned in the storm surge of idiotic queries.

“Is the interest on a loan to a friend deductable?”, one nearly shouted.

“My sister’s boyfriend lives with us..can I claim him as a dependent?”, said another with visible disdain.

And my favorite:

“Is birth control considered a medical expense?”

Cursing my choice of words, I sweetly replied (while gritting my teeth) that I had no idea and that a CPA specializing in individual taxes would be their best bet to obtain answers.

The group looked bewildered and one of them mumbled, “I thought you were an accountant.”

After thinking for a moment, I had to give credit where credit is due. The last comment made some sense.

As the children continued singing, I mentally debated the point. After all, taxes are a specialty of the accounting profession, and therefore, I should at least be able to comment intelligently on the topic.

My brother is a family doctor. If asked him about Cardiology, Neurology or Orthopedics he would surely be able to give a general response based on his knowledge of that particular area.

My father has a doctorate in Chemistry and I have heard him comment many times about Physics, Geology and the other physical sciences.

So why couldn’t I answer them? Why is the other accounting and financial knowledge I have so non-transferrable to taxes?

As the kids got up to perform a song using kazoos (many of the parents started to go pale at this point), I chided myself for not immediately seeing the obvious answer.

Simply, because the tax code is rule based and not principles based.

The tax code is created by Congress and is subject to all the whims, exceptions and favoritisms of the political process. What is deductable today may not be tomorrow. What is considered non-taxable income today may be considered taxable tomorrow.

All it takes is a change of public opinion or lobbying pressure and presto… there is a new rule. So to be conversant in taxes you have to be on top of all rule changes. There are no basic unchanged principles to fall back on.

Now we begin to see the value of principles in accounting.

Principles are much broader than rules and are also harder to change. Indeed the dictionary definition of a principle is:

“An important underlying law or assumption required in a system of thought.”

This is precisely why my brother and father can comment on other specialties within their professions. Red blood cells perform the same function in Neurology and Cardiology and the principle of gravity applies just as much in Chemistry as it does in Physics.

A change in principle in these areas would be truly revolutionary and be subject to intense peer review and debate.

This leads us to our concerns regarding US GAAP accounting. Over the years, USGAAP has had so many patches, fixes and updates applied that it has become more of a rules based system than one based on principles.

We see three basic problems with rule based accounting regimes. They are easily circumvented, they remove professional judgment from the process and they become so complex they cease to be useful as a decision making tool.

Rules based systems can be easily circumvented because they are so specific. It’s like old adage about adhering to the letter of the law rather than the spirit of the law. We have previously given the example of the 3% rule for special purpose entities(SPE).

Specifically if a company can convince an outside party to put up 3% of the equity then the SPE debt does not have to be reported on the company’s balance sheet. So a company that owns 97% of an entity is not required to reflect the debt of that entity on its balance sheet.

Professional judgment is key in accounting. Businesses are complex and are constantly in flux. New types of transactions, ownership structures and compensation arrangements are constantly being discussed and implemented. Rule based structures tend to paralyze accountants into waiting for guidance from auditors and regulators who are loathe to go out on a limb for liability and political reasons.

Finally, there is the unnecessary complexity. US GAAP has lost a lot of relevance in making management decisions. How many companies do you know that use their 10Q for decision making purposes? In many cases companies have duplicate financial functions, one concerned with external reporting (General Accounting) and the other with management reporting (Financial Planning & Analysis).

Further, companies have taken to reporting non-GAAP numbers to the investing public. The whole system has become so muddy that companies are resorting to nonsense like this:

We do see some hope in IFRS, which seems to be making its way to the US. While no system is ever perfect, IFRS does seem to rely much more on professional judgment and principles that US GAAP. For information on how you can learn more about IFRS click here.

The kids finished their performance and charged toward the dessert table. There were screams of joy as the glucose hit their bloodstream. My son came to me with his best friend in tow and gave me a hug. They were both smeared with chocolate.

Behind me, one of the mothers was chattering on about how she had to buy a new skirt after each preschool graduation.

I wonder if that’s deductible….

Have a great week,

Michael Bechara
Managing Director
Granite Consulting Group Inc.
mbechara@consultgranite.com
www.consultgranite.com