I recall a discussion in the mid-1990s as though it were yesterday.A case was made that dynamic hedging meant that everything would work out in the end and hence should not be reflected to have either gains or losses in a given reporting period.

As a member of the Financial Accounting Standards Advisory Council for the Financial Accounting Standards Board, I suggested that that would mean no accountability on an interim basis for the performance of the hedge, which seemed to me analogous to not keeping the score by inning at a baseball game.

A difference exists between what is expected or planned and that which is actually accomplished. Since those days, experiences such as Long-Term Capital Management and, more recently, hedge funds that are heavily committed to the subprime mortgage sector, have aptly borne out how wrong the administrators of hedge funds can prove to be.

The quagmire that has emerged in the financial reporting arena stems from a preoccupation with perceived relevance at the cost of verifiability. Yet I believe that misperceptions of relevance have dominated, and both standard-setters and regulators have accorded totally inadequate attention to whether or not representations made can be effectively audited.

The common assertion is that fair market value is the equivalent of relevant information to users of financial statements.

Prior to the 1990s, the focus was on historical cost, which at the time of acquisition is equivalent to market value. Realized gains and losses were of relevance, rather than unrealized gains and losses. This meant that you did not assume relevance of market values not accessed. I mean, who among us does not have a story of how much profit we might have had, if only an asset we owned had either been sold or not been sold at a particular point in time? It matters little to our current economic position that we could have held onto that first share of Microsoft stock or Warren Buffet’s enterprise. In like manner, not selling shares in the heyday of some investment, such as an airline, rather than holding on until bankruptcy and wallpaper emerged, may be interesting anecdotes, but are unable to save the actual economic setting in which one is found.

In my past writings, I have posed the question: “Assume that you went to a Las Vegas casino with $10 and won $2,000 on the first day of your vacation. On the second day, you lost the entire $2,010. Would you say you lost $10 or $2,010?”

I believe that this question can be translated directly to the dot.com era, the Enron debacle and many of the current investors’ complaints in the subprime sector. One may enjoy double-digit returns while the conservative investor barely covers inflation, but risks will take their toll, and losses may well emerge. I suggest that in each of these cases, the relevant question is not what might have been, but what was. The real underlying profit or loss is the difference between what one paid for the investment and what one received when it was liquidated, alongside earnings generated from its use. The double-digit returns may be mere illusions that evaporate before they are ever realized. Their relevance only exists if realized.

The problem with financial reporting has been the growing reflection of illusive market movements, without the anchor of actual participation in that market in the form of a transaction. Historical cost may grow stale between the time one has a transaction to buy and another to sell, with an elongated holding period. However, while that cost number may be stale, it is reality and hence has relevance. The fact that the current market value is tenfold that quantity may be interesting to know and may help one forecast, but unless that market value is actually cashed in, it has questionable relevance to the holder of the asset. As soon as the market dips, the asset holder remains in the same position in terms of their stake. What has changed are others’ transactions.

I have read with interest the media’s discussion of how overall market returns fail to correspond to the individual’s experience, since it is the timing of the buying and selling that matters. Increasingly, research and market studies have admitted how markets are affected by the behavioral reactions of “herds,” rumors or whispers in the marketplace, and even distorted information peddled intentionally by defrauders. Studies of rags to riches usually bear out the friction existing between bandwagons and entrepreneurs. For example, the decision not to cash in on the market because it is viewed as inadequate for the value held is a common gift of entrepreneurs.

When the software underlying today’s Microsoft was not sold to IBM, it contained the potential for the success that the markets have witnessed from those early days of information technology. Many corporations regularly announce that they are buying back their own stock for their treasury because of their belief that it is undervalued.

How many of us have chosen not to sell something at one point in time due to the belief that the market value offered is inadequate? How many of us believe we have sold things to others at more than their perceived value? How idiosyncratic are such assessments, and are we better served by focusing on what was actually bought and sold by an entity or what others, on average, chose to do?

Few understand that our current position of focusing on market value stems from the Securities and Exchange Commission’s initiative launched at its Nov. 15, 1991, conference titled “Market Value Accounting.” It was a reaction, in part, to the travesty of the S&L debacle of the 1980s. Yet rarely is good legislation, regulation or standard-setting a result of over-reaction to current or past problems. In truth, the primary lessons of the S&L crisis should have been the holes in appraisal valuation, the problem of related-party exchanges, and the perverse effect of government subsidies. Many are unaware that political intervention and regulatory mandate overrode then-generally accepted accounting principles which, if permitted to be applied, would have revealed the depth of the problem far earlier, facilitating more timely market correction.

Too close a parallel seems to arise in today’s political reaction to the subprime sector. The lesson of that sector should be that imprudence in lending would reveal itself and those benefiting from short-term, double-digit returns before that revelation should likewise incur the losses when the risk comes home to roost. Yet political intervention, including rate cuts, abrogation of contractual terms, bailout proposals, and misdirected concerns for those who actually benefited from credit ill-extended, will have exactly the opposite effect from that supposedly intended. It will slow the market’s adjustment and have long-term distortions similar to those created by the past decisions to downplay verifiability.

Whether something can be audited should be the paramount question posed whenever an accounting treatment or regulation is proposed. If not, I would assert that information does not result, meaning that relevance is a myth. I am reminded of the Rudyard Kipling wisdom, “If you can keep your head when all about you are losing theirs and blaming it on you,” which ought to be embraced by those directing the content of financial reporting. Return to what has happened, not what might have happened — find that verity lost.

Wanda A. Wallace, Ph.D, is the John N. Dalton Professor of Business Emerita of the College of William and Mary, and has served on the Financial Accounting Standards Board’s Financial Accounting Standards Advisory Council and the Comptroller General’s Government Auditing Standards Advisory Council.

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