An ironic question asks why people don't notice the "elephant in the room" when a big issue is unaddressed, even though its existence is painfully obvious.
In that vein, this column asks: Why is modern accounting still systematically depreciating assets? Why are regulators and standard-setters oblivious to depreciation's glaring flaws while they quibble with less significant issues?
As for us, we call this elephant "duh-preciation" because it's a naive, ignorant, crude, ultra-simplistic and otherwise unsophisticated response to demands for useful information about productive assets. It is clearly an unacceptable anachronism.
A BRIEF HISTORY
We dusted off a 1989 report, A History of Federal Tax Depreciation Policy, by David Brazell, Lowell Dworin and Michael Walsh that was distributed by the Treasury Department's Office of Tax Analysis. Its brief history astonished us by saying that, "Depreciation accounting, as we recognize it today, began in the 1830s and 1840s." We knew this practice was old, but we had no idea it was that ancient! They also explain that duh-preciation gained tax acceptability 101 years ago when the Supreme Court supported its deductibility, thus promoting its acceptance for financial reporting.
We've said it in prior columns and we'll say it again: Accounting practice cannot be accused of progressing at a glacial pace; after all, glaciers actually move.
ASSESSING THE DAMAGE
Because duh-preciation is nothing but a made-up number that has no correlation with any real event, it leaves significant and abundant havoc in its wake as it drags its primitive and ponderous body through financial reporting.
Consider these examples:
Earnings: Systematic duh-preciation contaminates every earnings statement by reporting an amount that is not observed and that cannot be rationalized as reliably estimating the cost of using up physical assets' utility.
Plant assets: For nearly two centuries, accountants have reported duh-preciable assets at original cost less accumulated duh-preciation. Negligently, they stand by silently while millions of users and commentators behave as if the resulting "book value" actually describes something real. Of course, this asset fiction creates an equity fiction as well.
Inventory: Some duh-preciation flows into inventory as an indirect cost, thus misstating this crucial asset. In turn, the misstated inventory misstates the cost of goods sold, gross margin, and other productivity measures. Further, selling prices are inefficiently determined if these allocated costs are used to set them.
Ratios: These duh-preciation bombs destroy the descriptiveness and usefulness of many heavily used ratios, including: debt/equity, return on assets, return on equity, and times interest earned.
USERS MAKE DO
Financial statement users have long identified these flaws and have chosen to work instead with incomplete EBITDA descriptions of operating results. Has anyone in the profession, including regulators and standard-setters, realized, much less confessed out loud, that consumers of our main product (financial statements) must filter out the useless parts?
Is it any wonder that stock prices and accounting numbers show so little correlation? Everyone should be amazed to find any correlation with all the duh-preciation debris strewn everywhere throughout the financial statements.
IS THERE AN ANKUS ANYWHERE?
Most everyone has seen elephants in zoos, circuses and parades. They are always accompanied by a trainer who carries a long pole with a hook on it, called an ankus. Amazingly, this small tool has the ability to move these large creatures.
Once upon a time, back in 1965, Professor Sid Davidson was serving on the Accounting Principles Board when it issued Opinion 6 that endorsed allocated duh-preciation. He tried to get his fellow board members and others to confront the duh-preciation elephant. However, being a minority of one and not wanting to lose influence on other issues in that opinion, he laid aside his ankus and decided to not dissent. Nonetheless, he expressed his reservations and offered a big challenge for the near future. Read these words carefully, mindful that they were published a very long 45 years ago (emphasis added):
"Mr. Davidson agrees with the statement that at the present time 'property, plant and equipment should not be written up' to reflect current costs, but only because he feels that current measurement techniques are inadequate for such restatement. When adequate measurement methods are developed, he believes that both the reporting of operations in the income statement and the valuation of plant in the balance sheet would be improved through the use of current rather than acquisition costs. In the meanwhile, strong efforts should be made to develop the techniques for measuring current costs."
Those words should humiliate every accountant. Even though Sid articulated the obvious deficiency of duh-preciation, the board members and all their successors have stubbornly resisted any and all efforts to develop and implement value-based asset measures (both up and down). How uncharacteristically naive he was when he expected the profession would soon develop dependable techniques for finding and auditing values.
Whenever we bring it up, accountants of all kinds defend the status quo with the same 180-year-old excuse that there is no way to estimate market values. What an embarrassment this should be.
We have written this column with the hope and expectation that those who read it will actually see that the big gray pachyderm is still right here in the room. Further, we want them to notice that it's really stinking up the place. It needs to be escorted out with solid resolve and with great haste.
THE OTHER HALF OF THE ELEPHANT
Strangely enough, though, standard-setters seem to get a half-glimpse of the elephant from time to time because they continually endorse asset impairments, which is nothing short of schizophrenic value-based accounting. Why are value decreases deemed reliable enough to warrant recognition but value increases are not?
We also point out the utter nonsense of comparing an observed market value with a fabricated (even random) book value to trigger a writedown. The explanation, of course, is auditors' dysfunctional stranglehold on standard-setting. They jump at the chance to force losses onto income statements, but don't want to stick their necks out by recognizing gains.
We look forward to the day when auditors will be held accountable (in court, if necessary) for their persistent negligence in blessing duh-preciation numbers that mislead users because they have absolutely no meaning whatsoever.
DISPATCHING THE ELEPHANT
Policymakers are the only ones who can get rid of duh-preciation and create more useful accounting. However, they are figuratively using their ankuses to deal with small rodents, instead of going after the obviously huge duh-preciation elephant.
Consider the brand-new exposure draft on lease accounting that has been touted as changing everything. It doesn't live up to that billing because it says that lessees must duh-preciate their capitalized rights to use the lessors' property while lessors are to keep duh-preciating their property, or at least the amount left in their accounts.
The ability, responsibility, and, yes, the public duty to turn duh-preciation and impairment accounting into full valuation based on current measures of the assets' market values lies squarely on the joint shoulders of the Securities and Exchange Commission and the Financial Accounting Standards Board (the International Accounting Standards Board has shown no inclination to tackle this issue). We implore the commissioners to instruct Chief Accountant Jim Kroeker to elevate this elephant's prominence so that accountants will actually have to confront it. This effort will involve asking FASB to grapple with both the old way's flaws (so they can be eliminated) and the new way's opportunities (so they can be implemented).
One transitional approach would require supplemental reporting of readily available market values, most notably insured amounts, but also others based on databases and recent transactions. In fact, managers and auditors could consult the same data sources they rely on to determine whether impairment has occurred.
Some 30-plus years ago, FASB tried this approach with SFAS 33 but mistakenly labeled it an experiment; limited it to only the largest companies; allowed loosey-goosey measures, including general price indexation; and recommended that the measures be unaudited. Understandably, users did not get very excited because this solution was only temporary, the information wasn't provided by all firms, the measures weren't faithful representations of value, and no one dared trust the unaudited numbers. Managers also choked the last bit of perceived usefulness out of their disclosures with disclaimers that warned everyone against relying on them.
It's got to be done differently this time.
THE TIME IS NOW
We think it's long past time, maybe even by 180 years, for accounting to get real about valuation, instead of continuing to claim that bogus duh-preciation and impairment numbers are relevant and reliable when they are neither. Now, SEC and FASB, reach down and pick up the ankus that Sid Davidson dropped, approach the large animal, and start poking it toward the door, sending it off to the proverbial elephants' graveyard where it should have gone to die long, long ago.
While you're at it, you need to do the same with all the other accounting elephants lurking around the room, namely inventory, pensions, intangibles, R&D, current/noncurrent classifications, cash flow statements, treasury stock transactions, and deferred income taxes, to name a few. Doing anything less than completely dispatching this herd will be a dereliction of your joint duties to produce useful statements that will make the capital markets better informed and more efficient.
The same old excuses won't take you off this hook.
Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authorsâ views are not necessarily those of their institutions. E-mail them at email@example.com.
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