In 2007, financial reporting is at a crossroads - with far-reaching implications for businesses, investors and the capital markets.Appropriately, the International Accounting Standards Board and the Financial Accounting Standards Board have held public discussions with stakeholders and leading experts in Hong Kong, London, and Norwalk, Conn., discussing the creation of a new conceptual framework for financial reporting.
These discussions, and the eventual launch of the new framework, are the culmination of a long-raging debate on what fundamental metrics should be provided by financial accounting and used to make investment and other resource-allocation decisions. Every business and investor in the world has a stake in the outcome.
WHERE THEY'RE HEADED
It appears that the boards are poised to move fully toward a "comprehensive-income" paradigm and away from the revenue-and-expense-matching paradigm. The comprehensive-income paradigm, if adopted wholesale, would likely lead to the eventual elimination of the earnings-per-share and net-income financial metrics, both of which are meant to indicate earning power. The Swiss food giant Nestlé and the Accounting Standards Board of Japan have both recently written the IASB and FASB expressing the need to retain the net-income measurement.
This shift toward a comprehensive-income paradigm is occurring primarily because the 20th Century revenue-and-expense-matching paradigm is dated and broken. While this is true, the cure, if it is a return to comprehensive income, may be worse than the disease.
The reality that comprehensive income is not an effective tool for the 21st Century can be found in the economics of everyday life. Any homeowner would likely agree that it is ridiculous to include a $100,000 appreciation in their home as income for 2006, and then include an $80,000 depreciation in 2007. This common-sense observation speaks to the classic need to separate current income from capital value changes. With such separation, income from holding the home might be estimated at $10,000 for each year.
Under the proposed comprehensive-income paradigm, no attempt is made to isolate windfalls, or to estimate average expected appreciation or income, or to yield anything analogous to the $10,000 income described above. Only the $100,000 appreciation and $80,000 depreciation swings are reported. Because the comprehensive-income paradigm does not measure net income or earnings per share, if it were implemented by itself, the very foundation for price-to-earnings ratio and return-on-equity analyses would simply vanish from financial reporting. The result for the average investor is more uncertainty regarding current and future investment performance, and, in turn, more uncertainty in financial and retirement planning.
Some would argue that such a loss is acceptable, because investors need only raw data with which to perform their own analyses and calculate their own versions of net income and EPS. As public policy, this perspective is deficient for three reasons. First, it is inefficient: Calculating net income and EPS is most economically performed once by a single reporting entity, rather than multiple times by multiple financial statement users. Second, it makes financial statement analysis more arcane and difficult, thus creating and furthering a specialist financial statement interpretation industry and precluding full public participation in the capital markets. Third, because of the resulting information gap, it pressures companies to reveal supplemental information, in particular trade secrets.
FINDING A THIRD WAY
Rather than moving back to the 19th Century, the IASB and FASB should move to the 21st. First, they should recognize that investors still need the net-income and EPS financial metrics. Secondly, they should recognize that neither the comprehensive- nor the matching-income paradigms are adequate for 21st Century financial reporting. Third, they should develop a new, modern paradigm that unifies and extends the two current paradigms, while reflecting the best of modern financial and statistical thinking. Accordingly, the accounting boards should bring the brightest minds in accounting and finance together to construct a third-way paradigm to serve investor needs.
Since the IASB has a moratorium on issuing significant new rules until 2009, and since convergence of standards is an objective of both the IASB and FASB, this is an ideal time to develop a third-way income paradigm. A third way should combine the best aspects of the two current income paradigms. Pursuant to the comprehensive income paradigm, it should yield balance-sheet entries based upon current market values. Pursuant to the original objective of the revenue-and-expense-matching paradigm, it should also yield an estimated average income that can be consumed, while leaving the capital base intact. The key to achieving a third way is to recognize that changes in asset and liability values have both income and windfall components. The income component should be shown above the net income line, while the windfall component should be shown below. Income for publicly traded assets can be estimated by multiplying the current price by the risk-free interest rate, which is the basis for current option pricing theory and practice.
The opportunity before us is truly historic. The vast majority of companies, stakeholders and investors recognize the need for a more modern, complete paradigm. It is now up to the IASB and FASB to move forward by forging a third way for the 21st Century.
Joel Jameson is an economist and the founder of Silicon Economics, a company that integrates economic theory and technology for businesses.
