The Ontology of FAS 5 – Thoughts Provoked by the E-Mail from RateMyProfessor.Com

Posted by Jeff Lipshaw

I confess to something of a recurring ontological crisis about the creation of business value, something that got aggravated this morning when I received notice from “optout@ratemyprofessor.com” that RateMyProfessor.com has been sold to MTV Networks, owners of among other things, VHI and Comedy Central, no doubt for an ungodly sum of money.  (Disclosure:  I have looked to see if any student has ever rated me on RMP out of what can be no more than a strange prurient interest.) 

Here is the question at the heart of the crisis.  Does the value of a business have “being” such that you can lie about it?  Is it real?  Can you touch or feel the value of RateMyProfessor.com?  I have started to read some of the vociferous debate between advocatesof historical accounting methodology (no doubt employed by Mr. Cratchit, left), on one hand, and advocates offorward-looking finance theory, on the other, as to which best capturesthe inherent value of a business.  Historical financial statements purport to “fairly represent, in all material respects, the financial condition of the business according to generally accepted accounting principles consistently applied.”  But we only need look at the gap between the book value of the net assets (or, more colloquially, the net worth) and the market capitalization of almost any company to know that net asset value does not equal market value.  (On Wednesday, my research assistants and I randomly picked Merck, which had a net asset value on its financial statements as of the end of 2005 – determined by accounting – of something like $17 billion, and an enterprise value – determined by the market – of something close to $100 billion.)

Since my impromptu talk at the AALS, I have been thinking aboutaccounting (particularly when the word precedes “fraud”), and whatprecisely the lie in more complex cases might be.  It is one thing tohave a case in which management gets a number in the roll-up of thequarterly financial reports, doesn’t like it, erases it, andarbitrarily substitutes another.  But what about all the judgment callsalong the way – rates of depreciation, capitalizing versus expenses,bill and hold, etc?

How lawyers factor into this metaphysical mess below the fold.

I want to focus on one microcosm of the issue here (cobbled in part from my article The Bewitchment of Intelligence, 78 Temp. L. Rev. 99 (2005)).  There is a dialogue thatgoes on between auditors and lawyers about when a contingent liability, like a claim in a lawsuit, moves into the footnotes, and then from the footnotes to an actual accounting charge as a liability.  And the words “probable,” “reasonably possible,” and “remote,” as, in the lawyer’s view, they apply to that contingent liability, are critical.

Under the Statement of FinancialAccounting Standards No. 5 (“FAS 5”, issued by the Financial Accounting Standards Board), part of the definition ofgenerally accepted accounting principles (“GAAP”), auditors use theword “probable” to indicate one of three different states of likelihood– the other two are “reasonably possible” and “remote” – that futureevents will confirm the incurrence of a liability. If an event isprobable and the amount of the loss is reasonably estimable, FAS 5requires that the obligation be booked as an accrual (an expense, andhence a charge to earnings) on the income statement and a liability onthe balance sheet. “Probable” is defined as “[t]he future event orevents are likely to occur.” Telling an auditor one has a better thaneven chance of losing a case in which the amount of the loss can beestimated is tantamount to incurring the expense.

Lawyers, on the otherhand, use loose language of probability to convey a sense of theoutcome to their clients on a regular basis. “Your odds of winning are50-50, 60-40, one in ten, etc.” The ABA has attempted to cover theseconflicting uses of language in its Statement of Policy RegardingLawyers’ Responses to Auditors’ Requests for Information: 

Concepts of probability inherent in the usage of terms like“probable” or “reasonably possible” or “remote” mean different thingsin different contexts. Generally, the outcome of, or the loss which mayresult from, litigation cannot be assessed in any way that iscomparable to a statistically or empirically determined concept of“probability”. . . . Lawyers do not generally quantify for clients the“odds” in numerical terms; if they do, the quantification is generallyonly undertaken in an effort to make meaningful, for limited purposes,a whole host of judgmental factors applicable at a particular time,with any intention to depict “probability” in any statistical,scientific or empirically-grounded sense.

So if the lawyers tell the accountants the likelihood of a loss is remote, the item never hits the financial statements at all.  If it is reasonably possible, it shows up in the footnotes.  And if it is probable, then GAAP requires that the lowest probable outcome be booked.

Financial statements are a mathematical model of some other independent reality (whatever it is).  By just a touch of lawyerly judgment, we can impact the model significantly (and who is to say whether that judgment is in good faith or not?) If we are not lying about what would generally be considered to be a piece of independent reality incorporated into the financial statements (“we shipped 10,000 widgets in the month of December”), but are manipulating the model (grossly or mildly), are we lying?