Earmark Podcast | Earn Free Accounting CPE

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Tom Selling: [00:00:00] App has a truth in labeling problem that accounting has. I want to emphasize my point is that accounting has never really been structured to measure earnings reliably. And the FASB concluded for good reason, that they should be in the business of measuring assets and liabilities and that reported whatever you want to call it, earnings or however you want to label it is a function of changes in assets and liabilities, not the other way around.

Blake Oliver: [00:00:24] Are you an accountant with a continuing education requirement? You can earn free Nasba approved CPE for listening to this episode. Just visit earmarked app in your web browser, take a short quiz and get your certificate. Hello everyone, and welcome back to earmark. I'm Blake Oliver, CPA, and today I'm joined by Thomas selling a leading voice in the world of accounting and financial reporting. Thomas is the author of The Accounting Onion, a blog known for peeling back the layers of complexity and accounting standards to expose their core issues. With a background that spans academia, regulatory work at the SEC, and consulting. Thomas brings a sharp and critical perspective to topics like gaps, shortcomings, the rise of non-GAAP metrics, and how accounting impacts corporate governance. He's also working on his upcoming book, An Honest Financial Accounting The Myth and Making It a Reality. Thomas, welcome to the show.

Tom Selling: [00:01:19] Thank you very much, Blake. It's a pleasure to be here.

Blake Oliver: [00:01:21] So your book, it is an honest financial accounting, the myth and making it a reality. What makes current financial accounting dishonest and what changes could make it more honest?

Tom Selling: [00:01:37] Well, I would say when I, when I think of the the term honesty and by the way, my title is going to be slightly different at this point. I'm going to use the words an accounting reformation, but still honest honesty still applies. And I, I think of it in in two respects. First of all, uh, generally accepted accounting principles have been set up so that management basically can game them to their own benefit. And that's fundamentally dishonest. Second of all, the standards themselves, I don't believe, are as honest as they could be in terms of measuring what they purport to measure, being consistent and and being rigorous. I think the standard setters in bowing to political pressure have have deviated from these kind of grounded principles.

Blake Oliver: [00:02:26] Let's talk about that first point management, gaming the system or.

Tom Selling: [00:02:30] Sure.

Blake Oliver: [00:02:31] How does that work?

Tom Selling: [00:02:32] Well, uh, I came here to to talk about that, um, in a fair amount of detail, but, um, the, the, I think the, the fundamental flaw that allows management to game the system is the persistence of historical cost accounting. Historical cost accounting, uh, requires First of all, it's not as relevant as other bases of accounting could be. Um, and it's also amenable to manipulation by management because of all the subjective judgments that can be made. And, you know, the timing of the recognition of earnings and essentially the lack of power of auditors to really rein in, um, unreasonable judgments.

Blake Oliver: [00:03:22] So what about the historical aspect of accounting makes it easy to manipulate.

Tom Selling: [00:03:29] Well, um, I don't want to I don't want to delve into the well-known tropes about historical cost, uh, lacking relevance. And, you know, and related to your question, I'll focus instead on how historical cost helps management gain the numbers. The root of the problem is somewhat esoteric, but important Historical. When we measure an asset, it's understood that when we measure an asset, we're supposed to be measuring a characteristic of that asset or an attribute. If you were to describe yourself, you might and you only had one number to do it, you would have to choose perhaps your height or your weight. Now, if, um, if that number was to help you decide whether or not you'd be a good fit for a basketball team, it might be your height. If that number were to decide whether you'd be a good fit for a football team, it might be your weight. I think conventional wisdom holds that historical cost is an attribute of an asset, and that's why we can use it, when in fact it's really not. It's an attribute of a transaction that acquired an asset. But it's not about the asset itself. Uh, the chief accountant who I worked under at the SEC, Walter Schutz, famously said in a speech, we report a truck as if the cost of the truck is the asset as opposed to the truck itself.

Tom Selling: [00:05:02] Um, think about buying a house. If you lived in a house for ten years. Um, you don't think about the cost of the house as an attribute, but rather you think about how much it would cost you to replace the house if you were to move, or how much you could sell the house for. So it sounds a little bit technical, but it's really important that the FASB puts itself out there as saying we're providing relevant information about the asset, but we're really not we're probably providing relevant information about the transaction. There's a few areas where this matters. For example, if you um, this is an extreme example, but I think it works for you. Let's say that you are deciding you're going to you're an airline Corporation, and you need to acquire three jets and you go to one of the suppliers. And they offer you two jets at the regular price. And you get to have the third jet at half price. To be delivered six months from now, you know. How much did the first jet cost?

Blake Oliver: [00:06:07] There's a few ways you can work that out, I guess.

Tom Selling: [00:06:10] Yeah, that that's the point. Um, uh, another, uh, but but if you really go to the really significant, uh, examples is you go to mergers and acquisitions accounting and you say, well, the value of an asset, the value of a company we bought is the amount we paid for it. And all of a sudden all this goodwill comes on the books because of the identifiable assets and liabilities they know how to add up to near the price that we paid for it. So we got to lump it in to goodwill, you know, and that, that that leads to a lot of problems. If management knows that we can risk overpaying and lump it into goodwill. And we don't amortize goodwill and it doesn't penalize our income statement. Then mergers and acquisitions are more likely to occur. And number one, that's efficient for a company, but it's inefficient for a company. But it's also inefficient for an economy. A lot of disruptions happen. A lot of people get displaced because managers go mergers and acquisitions crazy. And they use accounting to make those M&A transactions look good, look good for them. But the most significant problems with historic costs are measurements that occur subsequent to the date of acquisition. Um, for example, um, there's the problem of cherry picking that you can sell the asset that will show the most gain this period because the carrying amount of the asset is this irrelevant historical cost number that essentially was the heart of the Enron scandal that Enron had power plants that were doing very well.

Tom Selling: [00:07:49] They've had them for a while. They were they were fully they were they were depreciated. And but Enron needed to juice their numbers. So what they did was they created a fictitious entity with essentially fictitious inventors that investors that they essentially sold those power plants to, recorded, took the cash retired debt, recorded the gain and really levered them very highly. Um, and added a lot more debt in these special purpose entities. They were able to convince the auditors that these were genuine sales. But in fact, what happened is that, um, these assets came back to Enron along with the debt, and they couldn't handle the level of debts they had. And very simply, that's essentially how Enron collapsed. And people didn't have warning because all this debt was off the balance sheet and all their income was being juiced by these Is sham sales that exploited the anomaly of historical cost accounting. Um, so the bottom line there is that, um, it creates historic costs, uh, can create perverse incentives, um, for management to, uh, to, to gain the numbers, uh, to their, to their benefit. So one example I gave you was cherry picking. Uh, the other major example is the issue of asset impairment. The reason why we have impairment standards and they're very complicated. And they take up hundreds if not thousands of pages of GAAP. Plus commentary is because of historic cost accounting.

Tom Selling: [00:09:28] If we were measuring if you if we were measuring your height or your weight, there is no concept of your height or your weight being impaired. But somehow we have this, um, this, this made up term impairment having to do with, uh, historic costs being so distortive that we need to make some adjustment to it. Okay. Uh, ironically, uh, it doesn't refer at all to the physical condition of the asset impairment, but it relates to is the ability to recover the cost of the asset through later operations. And the rules here are extremely prosaic and very, very friendly to management. Uh, for example, let's just say you have an asset on your books with a carrying amount of $1 million. That's its amortized historical cost. And the future cash flows for that asset is $1,000,001. And that future cash flow of $1,000,001 is going to occur five years from now. Under US GAAP, that asset is not impaired because under the, um, convoluted theory of income, under historic cost, you are going to have a profit if your expected revenues exceed allow you to recover your historic costs. Disregarding time value of money. Disregarding everything else. But if I change this example and I said that the cash flows were going to be $999,999. In other words, if I reduce the cash flow by $2, I'll have an impairment worth 100 hundreds of thousands of dollars. So there's this raise.

Blake Oliver: [00:11:08] How does that work?

Tom Selling: [00:11:09] Well, well, the reason well, basically the impairment test is called the two step test. The first step is are there, um, are there indicators of impairment?

Blake Oliver: [00:11:21] Right. Well, what I mean is how could a, how could a decrease of $2 in the expected future cash flows lead to an impairment of 100 hundreds of thousands of dollars?

Tom Selling: [00:11:30] Because the trigger to measure the impairment is whether or not the expected cash flows are greater than or less than the carrying amount of the asset. Got it. And then when you measure the cash flows, of course, you got to discount the million dollars, more or less the present value. And that will come out to maybe $600,000. So the carrying amount of a million with a fair value of 600,000 means you have an impairment loss of 400,000.

Blake Oliver: [00:11:57] Okay. So to summarize what you're saying, uh, if I have this right. Gaap is mostly based on historical cost, right? And it is very distortive. It distorts uh, a lot is what you're saying because.

Tom Selling: [00:12:14] Number one is it lacks relevance. Number two is it creates opportunities for management to game the numbers.

Blake Oliver: [00:12:23] And then okay. And the gaming of the numbers is because like you gave an example of what Enron was doing with the off balance sheet financing. Right. The creating these creating revenue out of nothing. Right. Same asset. Different entity. Well, how else? How else does that work?

Tom Selling: [00:12:39] Well, well, in this particular case, let's continue my example just a little bit. Okay. The the issue may not be that the asset became impaired. The issue may be that management under depreciated it for a lot of years. So part of the game is how many years do you want to depreciate it.

Blake Oliver: [00:13:00] Okay. So we have the historic cost. You know the way you depreciate can really change earnings right. Um, you mentioned there's like different ways to measure that historic cost in the first place. Uh, what else did you have any other examples of that you wanted to share?

Tom Selling: [00:13:15] Well, I've got a lot of examples that could get. They could get pretty pretty pretty technical.

Blake Oliver: [00:13:20] So so I guess my question then is like, I mean, historic cost is basically like the foundation of the balance sheet. So what is the alternative to that? I mean, what else do you measure?

Tom Selling: [00:13:32] Well I'd love to talk talk about that. What are the alternatives. Let's, let's let's briefly think about the alternatives. Um, that, um, uh, that, that that are out there. Um, if you think about economics, if you've taken a finance course, you know that the value of an asset is the present value of the future cash flows that that asset is going to generate. Um, and so one way to, um, measure an asset is at its economic value, uh, another way to measure it. And we'll, we'll go through the choices later on. But let me just get them out there. Okay. Another way to measure it is the way the FASB does it when they depart from historic cost, and they use what's called fair value, they have a notion called fair value. Um, we, um, academics might call it exit value in the sense that it's the price you would get if you were to sell the asset today. And um, and so.

Blake Oliver: [00:14:31] And that could be a fair market value if there's a market for it. We just saw this change with crypto assets. Crypto used to be measured at historic cost. Now we're able to measure it at the fair value.

Tom Selling: [00:14:45] Which I thought was one of the. Which is what I thought was one of the silliest. Silliest. Um.

Blake Oliver: [00:14:53] I was going to ask.

Tom Selling: [00:14:54] You about.

Blake Oliver: [00:14:54] That. But you said that you were just talking about how historic cost is not ideal.

Tom Selling: [00:14:59] Well, essentially. What? No, no, I'm measuring crypto at fair value is reasonable. The band aid, as I understand it. I haven't looked at this in a while, but I remember reading about it when it came out. Um, the FASB took a long time in actually pronouncing how crypto should be valued in the interim. And this is my understanding from what I read, the audit firms took over and they said, well, crypto is really an intangible asset. As such, it should be um, we should look at the we should make an analogy to other intangible assets like goodwill. And the way we account for those assets is that we account for them at the cost to acquire them. And then they sit there like cream cheese on a bagel on our balance sheet until we until we dispose of them. So, um, even though crypto is used in exchanges, purportedly just like cash is, uh, the, the firm's, uh, in order to satisfy their clients, um, for a while made this analogy to allow crypto to just sit there like cream cheese on a bagel instead of be subject to volatility and, and, and create volatility in earnings that management didn't want.

Blake Oliver: [00:16:17] But now we are creating volatility in earnings because we're marking them to market. We're we're we're now showing them at fair value. And this is the part that I don't understand.

Tom Selling: [00:16:27] Uh but before before you get to that and I think that's a good thing.

Blake Oliver: [00:16:30] Okay.

Tom Selling: [00:16:31] Go ahead.

Blake Oliver: [00:16:31] Well, so I agree we should also ideally show assets at their fair value on a balance sheet. Like if I'm an investor that's what I want to see. I don't want to see some historic value that's meaningless to me as an investor. But then the part that I have trouble with is that the changes in the unrealized, the unrealized gains and losses are hitting earnings. I don't like that because I feel like that's going to be hugely distorting, uh, you know, earnings, especially if the markets are really frothy. Right. If there's a bubble happening right, it could push everybody's earnings up and then suddenly slam them down. You know it's not doesn't have anything to do with operations.

Tom Selling: [00:17:13] I think that there's a conventional wisdom out there that there is a right number for earnings. And even though it's kind of like pornography, we don't know what that number is, but we would know it when we see it. And we certainly know we think we know when, uh, when something is distortive to earnings. Um, I think that conventional wisdom is wrong. And if you want, I'll tell you a story to explain why. Okay, sure. But before I do that, you know, before I do that, let's go back to the other alternatives real quick. So alternatives to historical we talk about historical costs are net present value of future cash flows.

Blake Oliver: [00:17:51] Okay.

Tom Selling: [00:17:51] Um they are fair value. The amount you could sell it for. Right. They are replacement costs. The amount you could replace it for. Okay. And there's a fourth one that I particularly favor. I'll kind of tell you. And it's going to be in my book called Deprival value. And Deprival value is kind of a hybrid between replacement cost and fair value.

Blake Oliver: [00:18:14] What's that word?

Tom Selling: [00:18:16] Deprival. Deprival deprival. How much you would be? How much disutility you would you would experience if the asset, if you were deprived of the use of the asset. Okay. If somebody took your house from you, the deprival value would be the replacement cost, because you would have to.

Blake Oliver: [00:18:36] Right?

Tom Selling: [00:18:37] So replace it.

Blake Oliver: [00:18:38] The houses that burned in the Pacific Palisades, right in LA. Deprival value would be the cost to build it again.

Tom Selling: [00:18:45] Exactly. Now, if somebody took your inventory, if you were a jeans manufacturer and somebody took your inventory of last year's jeans, last year's styles from you, your deprival value would not be the replacement cost because you weren't intending to replace them, but your deprival value would be how much you could get for them when you sold them in Filene's Basement. That would be an exit.

Blake Oliver: [00:19:08] Okay. Got it.

Tom Selling: [00:19:09] So it's kind of a hybrid between between the two.

Blake Oliver: [00:19:12] And is that your preferred?

Tom Selling: [00:19:13] Uh, yeah. We could take a long time to develop that. Okay. Um, but but but, uh, your initial question was, um.

Blake Oliver: [00:19:27] Well, the question that kicked all this off was, you know, what makes current financial accounting dishonest? And then what fundamental changes would make it honest?

Tom Selling: [00:19:36] Oh, yes.

Blake Oliver: [00:19:37] So it sounds like you're saying that it's historic cost accounting is making it dishonest because we've got the ability to manipulate earnings. Right. Right. Through a variety of methods that adjust that cost. And then we've got. And you're talking about there's alternatives to that historical cost. You've laid out four. So I guess.

Tom Selling: [00:20:00] I don't want to put words in your mouth, but the part that I'm hanging on to was that, um, if not historical costs, what is the method that will give us the right amount for earnings?

Blake Oliver: [00:20:12] Yes. Because that's what I mean. We want an accurate balance sheet. Right. As we want an accurate income statement. And we want earnings to To reflect what is really happening in the business. The economic value that the business is creating.

Tom Selling: [00:20:29] I'm going to try to tell you a story and try to convince you that the best we can do is get an accurate balance sheet.

Blake Oliver: [00:20:36] The best. That's the best we can do.

Tom Selling: [00:20:38] Well, the best we can do is get you an accurate balance sheet and give you enough detail as to the changes those balance sheets into the into the change of that balance sheet so that you can construct a measure of performance. If you want to call it earnings, you can construct a measure of performance that you think is value relevant. Okay. Okay. Okay. So here's the story I'm going to tell you. Um, imagine um, the extractive industries. Okay. That's that's a very, very large part of the economy. It relates to oil and gas, energy, metals and minerals. Okay. Okay. And the basically. The main reason why gap does a lousy job reflecting the performance of extractive industries is because of the length of time between value creation and the realization of value.

Blake Oliver: [00:21:37] Right? So, uh, you got to dig a mine. You've got to find the oil. Is that what we're talking about?

Tom Selling: [00:21:43] Exactly.

Blake Oliver: [00:21:44] It takes a long time to develop that resource.

Tom Selling: [00:21:46] I'm pulling. I'm pulling a number out of my my head here. But let's just say, for the sake of argument, that 80% of the value created by an oil and gas company occurs when they discover reserves. Okay.

Blake Oliver: [00:21:58] Okay.

Tom Selling: [00:21:59] Yeah. Now, you you would call that earnings, right? When they discover reserves economically you would call that earnings. The market would because there's an 8-K file and says we've discovered it. You know this is where it is. This is the quality of it. You know, this is what our initial tests show. Okay. So and the stock price goes up.

Blake Oliver: [00:22:19] And we have the right to extract it and.

Tom Selling: [00:22:22] The stock.

Blake Oliver: [00:22:22] Price will go up.

Tom Selling: [00:22:23] Yeah. Yeah. Well, perhaps we have some. Maybe.

Blake Oliver: [00:22:27] Right. Or we have the ability to extract it.

Tom Selling: [00:22:29] Well somebody does or something. Yes. Okay, let's just let's just say that 80% of the value created by an oil and gas company occurs when those reserves are discovered. Right. But this is a question for you. When does gap recognize the first penny of those earnings?

Blake Oliver: [00:22:46] Well, I guess they have to deliver the product, right?

Tom Selling: [00:22:49] Yes. And when do they deliver the product?

Blake Oliver: [00:22:51] Uh, well, I guess if it's like Exxon, then it's they've got to ship that raw oil.

Tom Selling: [00:22:59] Somewhere between 5 and 50 years later.

Blake Oliver: [00:23:01] Five and 50 years.

Tom Selling: [00:23:03] Yeah.

Blake Oliver: [00:23:03] Okay.

Tom Selling: [00:23:03] It's going to take five years to develop it. You turn the spigot on, the last drop is going to come out 50 years from now. Okay. Right. So the point is that there is a huge disconnect. You know, oil and gas, minerals. Rules. You can talk about lithium, you can talk about copper, you can talk about silver. Um, this is this is probably the most extreme example of the vast disconnect between a focus on earnings and underlying economics.

Blake Oliver: [00:23:32] Right. Because you're saying the market, the market sees the value as soon as they discover the reserve, uh, the, the the the mineral or the, the oil, they're going to extract and, and accounting GAAP doesn't recognize that as happening until years later.

Tom Selling: [00:23:49] Right.

Blake Oliver: [00:23:50] So there's a timing problem here.

Tom Selling: [00:23:52] It's a huge it's a this is probably the most extreme example the timing problem. But I would say the timing problem uh, is um what's what's the word I'm looking for. But basically is almost universal.

Blake Oliver: [00:24:07] Uh, pharmaceuticals similar.

Tom Selling: [00:24:09] Perfect example pharmaceuticals. The value creating event is the discovery of a new drug. Yeah. Think of how many years goes by before you get the first dollar of revenues. Think of how many years go by before you get the last dollar of revenues. But the so there's a big connect here right.

Blake Oliver: [00:24:28] And the value of that drug is not on the balance sheet. That's well well some of it is because we accumulate costs to develop it. But but the actual like what the investors would consider the value of that drug is much higher than what maybe the costs are that we've accumulated most of the time. Right.

Tom Selling: [00:24:48] That's true. It is true that current GAAP would capitalize the R&D for developing that successful drug. And, uh, and just by the nature of the way R&D works, you know, for every 99 projects, every hundred projects, one is successful. The vast majority of R&D ought to be expensed, and 1% of it ought to be capitalized. And the cost of that product probably bears no relationship whatsoever to the future benefits.

Blake Oliver: [00:25:17] Yeah, and that's why if you buy a pharmaceutical company, you're going to have an enormous amount of goodwill.

Tom Selling: [00:25:23] Well, potentially, if they have an amount of unrecognized assets. Right. Just, just just the same as this, the same as oil and gas. You have an enormous amount of the the unrecognized asset is the value of the reserve.

Blake Oliver: [00:25:36] So.

Tom Selling: [00:25:37] So let me, let me let me keep going.

Blake Oliver: [00:25:38] Keep going.

Tom Selling: [00:25:39] Okay. So what I want to illustrate with this example is that for accounting to be useful we really have two choices. One choice is to focus on valuation. We could develop an accounting system that estimates the present value of those reserves when they're discovered and reports them as an asset. And, you know, with double entry accounting, if we were to do that, we debit the asset and we credit income. We don't do that because there are huge problems of Implementation. Okay, in order to do that, we we we have to make estimates of costs over huge time. Uh, we have to, um, and, and we have to do a whole bunch of other stuff that are not necessarily within the objectives of accounting. And on top of that, in order to make those estimates, we have to we have to anticipate we have to bake in management's decision making. There's not one way to, to to extract reserves. Right. Um, and uh, and not all reserves are the same. So it's not clear to me that accountants can serve society, um, any better than, uh, the better than the market by coming up with these wildly unreliable estimates. The. So the other approach is to measure the assets that are used in a manner that is relevant in a manner that's relevant to decision makers, and report in detail how they change over time. So we we can't measure the future value of the assets, but we can measure the cost of the assets in that oil field. We can measure how much it would cost to replace those assets in the oil field if we had to. And accounting can track how those assets are used. You know the the effect of decision making. So essentially, uh, I believe that the best we can do in accounting is to measure a subset of economic assets and liabilities and measure them at their current cost. Okay.

Blake Oliver: [00:28:03] The replacement value.

Tom Selling: [00:28:04] I think, in the in this case would be replacement value. Now this this is not just true with oil and gas. There's other industries that have similar limitations as you. As you mentioned, the pharmaceuticals business is driven by the discovery of drugs. Other businesses are driven by their long term relationships with customers, like construction, like telecom.

Blake Oliver: [00:28:30] Subscription businesses.

Tom Selling: [00:28:31] Subscription businesses.

Blake Oliver: [00:28:32] It's all about the long term customer relationship, the lifetime value of that customer.

Tom Selling: [00:28:36] Yeah, the Netflix, just like discovery of reserves, is the value creating event for those businesses. The value creating event is the engagement of a customer.

Blake Oliver: [00:28:46] But that is not when accounting recognizes the value.

Tom Selling: [00:28:48] That's the point. That's the point. So accounting. So what I'm saying is that, um, uh, it is to, to focus accounting on trying to measure earnings is just an impossible task. It's, it's it's more impossible than identifying pornography. So so so the best we can do is focus on and the the FASB has this right. The FASB says that, you know, in an ideal world, if politics weren't such an issue, we would be focusing on measuring assets and liabilities and reporting the changes in assets and liabilities in ways that people might find useful. Because to focus on earnings, uh, is takes us down a rabbit hole.

Blake Oliver: [00:29:36] Well, and what I like about that is that it's very clear what our job is if we make that the job. Here's the starting value. Here's the ending value. Here's the change. And you know, perhaps why that happened. An explanation. And then you allow.

Tom Selling: [00:29:53] Sorry to interrupt. You're going to like my book. If you ever if I ever get around to writing it.

Blake Oliver: [00:29:57] You're gonna. I'm really looking forward to it. Um. So what what I like about that is. Yeah, it's very clear. Uh, you can just go down the balance sheet and you can, you can you can see what has happened. And then if somebody wants to construct earnings out of that information, they can and they can do it however they like by using whatever changes in the assets are relevant to, in their view, the operations of that business. So if you and I guess investors already do this in a sense like that's what EBITDA is, it's a way of stripping out certain changes from earnings that accounting considers to be part of earnings. But investors don't care as much about.

Tom Selling: [00:30:37] Right. But but in my view investors would be supercharged by having much, much, much more detail. Right. The the the current level of aggregation in accounting doesn't really give you, uh, or the current level of aggregation was essentially determined when we had manual accounting systems, we should be able to do much better. I mean, we don't need to give you we don't need to give you a journal of every single transaction. We don't want to do that. Of course. No, no, but but we should do a much better job of providing the detail and being transparent. But again, transparency is, um, doesn't work to the benefit of management. So management fights transparency. And I can, you know, tell you of a number even even in a statement of cash flows management fights tooth and nail a requirement to have a statement of cash flows using the direct method. In other words, to show cash receipts from customers, cash paid to vendors. They fought that tooth, tooth and nail for decades at, at, at the FASB. So these are the things that have to be these are the things that have to be overcome in my, my, my, um, my ambition. And this is probably, uh, tilting at windmills. Windmills is, is that I were to provide a, A comprehensive specification of what's required. In other words, instead of 8000 pages of GAAP, 1 or 200 words of a description of the kinds of things we've been talking about here, 1 or 200 pages of the kinds of things we've been talking about here. Then enough people, I hope, will start to ask, well, why can't we do this instead?

Blake Oliver: [00:32:25] So I find this fascinating because, um, you know, you started with the example of oil and gas extractive industries, which, you know, I don't have experience with that. Um, but I, I appreciate the example, and I, I totally get it.

Tom Selling: [00:32:41] For your listeners. I actually do have experience with oil and gas.

Blake Oliver: [00:32:44] That's your background?

Tom Selling: [00:32:45] That's not my background, but I've had a couple of consulting engagements and teaching opportunities.

Blake Oliver: [00:32:50] It makes sense. Right. Like that that. Yeah, it's it's when you strike oil.

Tom Selling: [00:32:55] I'm a semi expert on Indonesian production sharing contracts.

Blake Oliver: [00:32:58] Okay. Uh, we'll have to do a separate episode about that someday.

Tom Selling: [00:33:03] Uh, no you won't.

Blake Oliver: [00:33:05] Yeah, that's right, we won't. Um, I mean, I like I like that example because, you know, I just think of, um, you know, I think of that movie, um, uh, what's the movie? Daniel Day-Lewis. Uh, where he's the oil man.

Tom Selling: [00:33:21] Oh.

Blake Oliver: [00:33:22] You forget? I forget the name. It's based on the Sinclair Lewis book, right? Yeah, yeah. Um. Oil.

Tom Selling: [00:33:28] Oh, yeah. Yeah.

Blake Oliver: [00:33:29] Anyway, there's there's a. I'll remember it in a second, but.

Tom Selling: [00:33:31] I'll come clean and say, I know of the book.

Blake Oliver: [00:33:34] There will be blood.

Tom Selling: [00:33:36] Oh. That one.

Blake Oliver: [00:33:36] Yeah.

Tom Selling: [00:33:37] So anyway, there Will Be Blood.

Blake Oliver: [00:33:38] One of my favorite movies. And, you know, he's an oil man. And, uh, you know, it's like when he gets rich, the moment when he gets rich is when he strikes oil. Yes. Right. That's when he gets rich. Like, that's the moment in the movie when he knows he's going to make it. So that is the event. That is when the value is created, is the finding of the oil. Accounting doesn't recognize that.

Tom Selling: [00:34:01] That's right.

Blake Oliver: [00:34:01] You have to actually extract it first.

Tom Selling: [00:34:02] It's a nonevent.

Blake Oliver: [00:34:03] Yeah, it's a nonevent. So I love that. And and so but my experience is in.

Tom Selling: [00:34:09] Or as we say in accounting, no entry.

Blake Oliver: [00:34:11] No entry. My experience is in software. Software as a service. Specifically, when I left public accounting, I went to work for a software company selling subscription software to accounting teams in corporate America. And the thing that opened my mind to alternatives to GAAP was when I realized that we had a controller and we were producing GAAP financial statements for our investors because we had to we had raised a series B at that point. That's when you got to get serious. But we never looked at them, and we looked every week at a whole set of alternative metrics called SaaS metrics, um, which is actually like its own branch of accounting. They don't think of it that way. The people who develop this are like finance people and tech people, but that's basically what they've created. And that always while I was working, there was like a point of tension for me, I couldn't reconcile. Here's what I learned in school and here's what we were actually doing.

Tom Selling: [00:35:15] I'll tell you a counter story to that. There were a lot of software companies who feel constrained by by GAAP and they'll say, well, here we are at the end of the quarter, we're going to have to in order to get meet our revenue targets. Yeah, we're going to have to, um, make some sales that meet that meet the criteria for recognition, but are not necessarily the best arrangement, the most efficient arrangements we can have with our customers.

Blake Oliver: [00:35:44] And, uh, you know, we we face that with our sales team. Yeah. Um, so to go to go back to this discussion of like when the moment of value.

Tom Selling: [00:35:52] I'm sorry to interrupt. I was also involved in a legal case once where I learned that a salesperson in the software business did not get his commission unless the transaction with the customer satisfied the criteria for gap recognition that quarter, that quarter.

Blake Oliver: [00:36:12] That's so strange. Um, well, and the issue is that in software, this is what I finally came to realize years later, is that in in software, in subscription businesses, the moment of value creation is when you acquire the customer, when they sign up as a customer. And that is because you can very reliably estimate what's called customer churn. After you have enough customers and you're you've been around for a number of years, you know exactly how many customers on average will leave after a year.

Tom Selling: [00:36:49] And you. Sorry to interrupt, but you also know the upgrades. You know you can also predict upgrades.

Blake Oliver: [00:36:54] Yeah, you can average that out across your customer base. You you can average your contract price. So we have these metrics like average contract price. We have a lifetime of a customer. Right. Which is the number of periods, typically years that they stay with you on average. You can calculate your churn rate, the number of customers, the percentage of customers that leave. And you can use these metrics to calculate lifetime value. So every customer that you bring on has a lifetime value, which can be reliably estimated. So I could say that every customer that I bring on has a lifetime value of X dollars. And so when I sign up that customer economically what is happening is I am basically adding those future cash flows to my business. I might get some of it now. I might get none of it now, but it's all coming in in the future. But that customer, those future cash flows, although economically real and very reliably measured are not on the balance sheet. And we don't measure the revenue from that customer until we begin to serve them. And here's the problem. It violates the matching principle. Because I have this all this cash in the future that I know is coming in, only a fraction of it is showing in my GAAP financials. But what is also showing in my GAAP financials is 100% of the marketing and sales expense to acquire that customer.

Tom Selling: [00:38:24] Well, let me say let me say now that we're talking about first, first of all, the matching principle. It's if you listen to the FASB and the concept statements, the matching principle no longer exists. But really, yes, that's correct.

Blake Oliver: [00:38:37] That's like foundational to accounting.

Tom Selling: [00:38:39] The matching principle is an income statement concept. The more the principle that the principle invoked to describe your situation right would be conservatism. That's under conservatism. You would recognize expenses. Uh, you recognize losses. As soon as you think you have them. But you don't recognize gains until you're almost reasonably assured, right, that you have them. So. But the FAA, the FAA is very happy under historic cost accounting.

Blake Oliver: [00:39:13] Right.

Tom Selling: [00:39:13] Um, and the way historic costs accounting has evolved to say that if you have expenditures and they don't meet the definition of an asset, they're expenses. Okay.

Blake Oliver: [00:39:25] Right. But see.

Tom Selling: [00:39:26] The customer let me finish. Okay. And they are happy with the mismatch you've identified. They say that's just you. You should be able to over. If you want to overcome that mismatch, do it with additional disclosures. Talk about the nature of your business and and things like that.

Blake Oliver: [00:39:44] But but but the distortion is so enormous that it makes really, really successful businesses look horribly unprofitable. And that's what happened with Amazon for years and years and years while they were building up their Prime subscriptions. Right. They understood the value of those Prime subscribers long term, but the market did not, because they were all that expense to acquire those customers. So they have all these expenses and they have no corresponding asset anywhere. It's on in the accounting world, there's no asset. And so what I'm saying is like, if, if I were to to design my own balance sheet and income statement for a subscription business, which I know I'm now growing one myself, I would want to actually I mean, there's two ways you could do it, right? One is you accelerate the, you know, you recognize the value you created when you acquired the customer early, and so that now you've got the revenue and the expense matching in the current period, or you defer some of that sales and marketing expense. And you, you you recognize that later over the life of the customer. Not immediately, all at once. I mean, because otherwise none of it really makes any sense. And the way we look at it in a subscription, well.

Tom Selling: [00:41:01] Let me say this. My view is there's no good solution to your problem. Well, I just just like there's no good solution to the oil and gas problem, right? There's no good solution to your problem. The best we can do, the best we can do is recognize a subset of assets and a subset of liabilities that meet a subset of economic assets, and a subset of economic liabilities that meet certain objective criteria and then measure them in relevant ways.

Blake Oliver: [00:41:29] Well, and the reason I like what you said, like your method suggested.

Tom Selling: [00:41:33] One other thing real quick. Okay. The one relevant way is the present value of future cash flows, right? But that's too subjective. Another relevant way is the current value to the company. Okay. In other words, how much it would cost to replace it if this was an asset that should be replaced.

Blake Oliver: [00:41:51] Well, so in this example, the present value of the future cash flows is reliably estimated like and Netflix knows. I guarantee you there's a spreadsheet somewhere at Netflix and they know exactly what a new subscriber is worth in terms of the present cash, the present value of their future cash flows because they know how long a subscriber is going to stick with them, right? But the market doesn't get to know that. Investors don't get to know that. But what I like about your method, where you talk about measuring, you know, the the asset at something other than historic cost in and you can compare the two the change and explain the change is that I could get all the information I need from that. Like if we if we recognized those, those customers and the future cash flows of those subscribers, if we were allowed to do that, I think we could create more accurate financial statements for subscription businesses.

Tom Selling: [00:42:44] Well, let's distinguish between two types of subscription businesses. First, one type is a new and growing business, okay. And the other is a mature business. For a new and growing business, your model isn't going to work too well because we don't have a lot of data to be as accurate as, say, Amazon. And so we want to ask ourselves, do we want to hang our hat on these kinds of estimates? Can we rely on auditors to push back on these kinds of estimates when they are unreasonable?

Blake Oliver: [00:43:15] Well, they won't, that's the problem.

Tom Selling: [00:43:16] Well, that's one of the problems. Now let's talk about the second type of subscription business. And that's the mature one. For the mature one, it kind of doesn't matter because they are more or less at a steady state. Uh, yes. Um, they are uh, incurring a lot of upfront acquisition costs for new customers, but they're also enjoying the back end revenues from their existing customers. Right. So it kind of balances out.

Blake Oliver: [00:43:42] Sort of. Unless. Well, then there's the the other, the third type is you have a legacy like software business that is switching from from charging licenses, perpetual licenses to subscription pricing, which is what Adobe went through. And they took a huge hit to their earnings because of that switch. Well, and that's because GAAP doesn't doesn't, doesn't. Uh.

Tom Selling: [00:44:08] But again, those those kinds of switches are disruptive. And you're asking accountants and auditors to predict the future in disruptive situations. And I'm not so sure accounting is appropriate for that.

Blake Oliver: [00:44:21] Well, so I agree that the the problem with trying to put the value of the customers on the balance sheet is the estimates, right? Because estimates are easy to manipulate. So you want to reduce the amount of estimates that are present in the value on the balance sheet.

Tom Selling: [00:44:38] Well, well, No, no. First. First of all, I need I need to tell you that my approach to base earnings on to base to base assets, on deprival value, that requires a lot of estimates, more estimates than, um, because you got to you got to estimate replacement costs. Now the question becomes we haven't talked about it and I don't think we really should talk about it today is who makes the estimates. Another perverse thing about our system right now is that it's like, um, the person who's making the estimate is the person who's going to be evaluated by the performance shown in the financial statements that the estimates, the basis of accounting is that management is responsible for the estimates. The auditors are responsible for determining whether those estimates are reasonable.

Blake Oliver: [00:45:25] Yeah, but the auditors do not have the expertise most of the time. A lot of the time to to challenge those estimates.

Tom Selling: [00:45:32] You're right. That's a big problem. I mean, we haven't uh, we can talk. I suggest that we talk about the problems with the auditing environment later. Yeah, but but I will admit to you that they're restructured, that they are, that they're, that they're inter inter inter interwoven that uh, but if you go to the kind of system where we depart from historic costs, then you have to ask yourself, well, who can appropriate make the estimates of replacement costs or fair value or whatever it would be. The analogy I like to give is imagine, imagine you were in college and you were taking a course and your professor said to you, um, uh, not only are you going to write your paper, you're going to grade your own paper, and you're going to give yourself your own grade. And I'll look at it too, but I'll change the grade only if I think your grade is unreasonable. Would you like that system?

Blake Oliver: [00:46:28] I actually had, uh, some teachers in school. I don't think it was ever in college, but I had some teachers that did that, and I hated the way it made me feel.

Tom Selling: [00:46:38] Well, it's because it's perverse. It's perverse for a lot of reasons. If you were if you were recruiting accounting students from a system like that where accounting students got to grade themselves. Yeah. You know, would you would you like that system?

Blake Oliver: [00:46:51] No, I.

Tom Selling: [00:46:52] Know, but.

Blake Oliver: [00:46:53] That's the system we have.

Tom Selling: [00:46:53] That's the way corporate governance works, that management gets to grade themselves. They set the estimates. And we know that auditors, first of all, even if they had a lot of power, their power is limited because they can only reject unreasonable estimates. Right. And we also know that corporate governance is broken because the CEOs pick their friends to be on the board. The outside, the outside. Directors are are are not as independent as we'd like them to be. But that's that's the perverse system we operate under. Right. But and that system fits hand in glove with historical costs.

Blake Oliver: [00:47:33] So how do you switch to. How do you get off of historical cost and not have this problem with estimates?

Tom Selling: [00:47:42] Yeah, I really don't want to talk about that today. I can.

Blake Oliver: [00:47:45] We'll save.

Tom Selling: [00:47:46] That. I can. I'd love to talk about that another time with you. I know you've and this is my open invitation to Maureen McNichols. Maureen, I hope you're out there. And I know Blake has talked to you. You're the auditing expert, and I think we could have a fantastic conversation about that question.

Blake Oliver: [00:48:04] I I'm really looking forward to speaking with Maureen. Uh, she is, uh, at Stanford, and that'll be great. I'm going to I'm going to make sure that she hears this.

Tom Selling: [00:48:14] Good.

Blake Oliver: [00:48:15] That'll be a good follow up.

Tom Selling: [00:48:16] You don't have to make sure she will hear. She will.

Blake Oliver: [00:48:18] Well, uh, Thomas, thank you so much for joining me and, uh, embarking on this wide ranging discussion. Uh, is there anything you'd like to add before we close it out?

Tom Selling: [00:48:30] If you don't mind, I want to quickly summarize just a little bit to tie tie things together real quick.

Blake Oliver: [00:48:34] Go for.

Tom Selling: [00:48:35] It. If I want to leave your listeners with anything, I want to tell you that gap has a truth in labeling problem that accounting has. I want to emphasize my point is that accounting has never really been structured to measure earnings reliably. And the FASB concluded for good reason, that they should be in the business of measuring assets and liabilities and that reported whatever you want to call it, earnings or however you want to label it is a function of changes in assets and liabilities, not the other way around. Nevertheless, historical cost measurements have been a gift to management to manipulate earnings. So I'm motivated by my rage at how managers use accounting to steal from shareholders. Um, once. And my view is that once managers. And the reason why I'm devoted to this is that once managers can no longer manipulate income, they'll have no economic reason to base their performance on earnings. Um, and that eliminating historical costs is a necessary but not sufficient step to achieve that goal. And that's come out in our conversation. We also need to reform, uh, other aspects of measurement and auditing and corporate governance, uh, etc.. And the choice that we have depends on the role that we envisage for accounting. Um, I believe we need a clear line between the assets recognized in accounting and other economic assets. Uh, focusing on the balance sheet does not mean that financial statements will be less relevant than they are now. I actually think that with the right amount of disaggregation, they'll be far more relevant than they are now.

Blake Oliver: [00:50:17] Thomas, thanks so much for joining me.

Tom Selling: [00:50:19] A pleasure, Blake.