Journal of Accounting and Economics. The paper is entitled, “Accounting standards and debt covenants: Has the ‘Balance Sheet Approach’ led to a decline in the use of balance sheet covenants?

My first reaction was to question what the author meant by a “balance sheet approach” because I’ve never heard a good explanation of what the alternative to a “balance sheet approach” would be. By that, I mean that no one has yet been able to give me a persuasive explanation of what an income statement approach would be that was devoid of reference to balance sheet amounts. In any income statement approach I’ve heard about, you still have to decide (for example) how much revenue to recognize, and you can’t decide that without thinking about cash you’ve received, a promise of cash you’ve received, an obligation you’ve satisfied, or an asset you’ve created in anticipation of delivering it to the customer. Each one of these constructs is either an asset or a liability. So every income statement approach I’ve heard about is inherently a balance sheet approach too. What am I missing?

I guess that’s why I decided to read the paper. I decided that a paper that dared include the label “balance sheet approach” in its title would probably have to define that notion somewhere. I found that definition on page 1 of  the August 2011 working paper, and I have to admit that I found it intriguing. The author describes the income statement approach as one in which the focus of standard setting is on the determination of net income [regardless of what it does to the balance sheet], while the balance sheet approach is one in which the focus of standard setting is on the valuation of assets and liabilities [regardless of what it does to the income statement]. Of course, an income statement approach defined this way presupposes a concept or definition of net income that is devoid of reference to the balance sheet, and (unfortunately) both the conceptual framework and the profession’s current thinking lacks any sort of definition for net income.  And without a definition of net income, I’m not sure we’ll ever resolve this debate.

But that’s okay for this paper because to me, its real contribution is to point out that debt contracts rely much less today than in the past on balance sheet amounts. We all may have different theories for why this may be, but among them is the idea that many more assets and balance sheets are measured today based on current or fair values, which makes them much less useful to debt holders who likely prefer more verifiable numbers. That seems to be the overall gist of the paper, and I encourage you to read it. As you do, keep in mind the following questions: Should the fact that debt contracts rely less on balance-sheet covenants be troubling to standard setters? In the days before there were so many fair values on the balance sheet, were debt covenants based on balance sheet amounts better at protecting debt holders?  Have businesses changed over the last twenty years in such a way that their own business models cause more uncertainty in the value of their assets/liabilities, and the accounting just reflects that better today? Can we blame standards entirely, or have standard evolved to reflect changes in fair value more often precisely because the underlying risks of assets and liabilities have become so much more uncertain?  Would you want to go back to a purely historical cost basis for some/all assets and liabilities?

That’s all the questions I have for now. Perhaps you have some questions you’d like to pose or some responses to my questions. Feel free to chime in.]]>