Recently, Accounting Today printed both an article by Joel Jameson (March 19-April 1, 2007, page 14) and a letter from Alfred King (April 16-May 6, 2007, page 8) that rebutted our long-espoused view that financial reporting should be based on market values.
Jameson and King make a number of points to support their positions, citing what they consider to be limitations on market-value measurement. We want to focus here on only one of their objections, because many consider it the most devastating argument of the bunch.
Their specific complaint is that market-based measurement introduces far too much volatility into financial reporting. Rather than turning us aside from our enthusiasm, we respond that they're merely repeating one of the oldest fallacies in accounting theory.
IS SMOOTHING GOOD?
By training and tradition, most accountants have been mesmerized by the paternalistic logic that they do statement users a favor by smoothing out the inherent natural volatility of economic data.
In the real world, value changes of individual assets and liabilities are anything but smooth. They are not uniform in size or direction, nor are they predictable from one year to the next. Rather, they often occur in essentially random and irregular bursts, either upward or downward, according to the supply and demand for the associated cash flows. This variability is an incontrovertible economic fact of life.
In what appears to be denial of this truth, conventional rationalization (as expressed in generally accepted accounting principles) holds that it is preferable, even essential, for accountants to even out the effects of these real value changes through totally artificial allocations over a period of years based on management's predictions of future events. With a hubris that is unjustified by economic facts, they then proceed to build financial statements around these assumed steady movements, instead of the real variability.
In contrast to the usual wisdom that such smoothing is good, we know that it is not. Rather than making statements more useful for predicting the future and assessing the past, smoothing renders them useless because they simply don't reveal the economic truth.
KING AND JAMESON
King and Jameson both presented the conventional view, and there are many in their camp. What they have going for them is decades of entrenched practice, which we cannot deny. After looking at it with a fresh eye, though, we characterize this justification as supply-side thinking, which means that reporting practices are shaped by the needs of those who prepare and audit the statements.
History shows that supply-side thinking has dominated accounting regulation from the beginning, because preparers and auditors filled most of the seats around the standard-setting tables. We think the condescending rationalizations that smoothing keeps users "safe" from the ravages of volatility are nothing more than subterfuges for writing rules that satisfy preparers and auditors who want to publish financial statements that are easy to verify and that project a financial image of stability and low risk.
LET'S LOOK AT FACTS
Although we could argue with Jameson, King and others about the wisdom of "protecting" the users against volatility, our academic training (and common business sense) teaches us that the way to resolve differences is to look at relevant facts.
In approaching this issue, many claims are made about what's good for users. Instead of arguing, it makes great sense to discover what users want. Are they really overwhelmed by volatility, or are they actually frustrated because all they get are filtered and smoothed financial statements?
In October 2006, an influential group of statement users spoke out about what they want in a report called A Comprehensive Business Reporting Model: Financial Reporting for Investors, compiled by the Corporate Disclosure Policy Council of the CFA Institute. The members comprise a bona fide "who's who" of well-known and highly respected financial analysts.
They don't mince their words. The first of their top 10 principles for reshaping financial reporting calls for putting user needs first, before the needs of preparers and auditors. What does that say about their satisfaction with the long history of supply-side rule-making? We read this statement as nothing less than a long-overdue manifesto for substantial reform in that process and in its results.
The council describes its desired results in Principle No. 2, which says, "Fair-value information is the only information relevant for financial decision-making." We don't see how anyone who truly seeks improvement in financial reporting can ignore this succinct and direct proclamation that users want market values, instead of allocated and otherwise smoothed historical costs.
USERS AND VOLATILITY
On the issue of volatility, the committee stunningly proclaims that "opponents of fair-value reporting argue that measuring and recognizing assets and liabilities at fair value in the financial statements introduce volatility into the financial statements. We argue to the contrary: If fair-value measurement results in greater volatility, then the measurement has merely unmasked the true economic reality that was already there. Honesty and volatility should not be tradeoffs."
They have even more to say on the importance of transparent reporting of economic value changes: "One of the most important evaluations investors must make is to ascertain the degree of risk to which an investment is exposed: the greater the volatility, the greater the risk. The risk is then weighed against the investment's expected returns. Reporting methods that mask true volatility do a great disservice to investors, impair their ability to make well-founded investment decisions and can result in inefficient allocations of capital."
We emphasize two key points here. First, there is no merit in the accounting profession's longstanding claim that it's doing users a service by protecting them from volatility. Second, managers are not even doing themselves any good by filtering out volatility, because doing so actually increases the risk that analysts impute to their securities, because the available information is far short of good enough. In turn, this higher risk forces stock prices down, not up, as management hopes.
The report includes many other compelling statements about the chasm between existing GAAP and what users need. We urge you to have a look for yourself, especially if the paternalistic arguments have comforted you in the past. (The report is at http://cfapubs.org/ap/issues/v2005n4/toc.html.)
PRECISION AND RELIABILITY
We would add one other response to a point made by our friend and colleague Al King. We agree that the existing nature of the asset appraisal process leads to imprecise results. However, imprecision is not the same as unreliability. If you ask 10 appraisers about an asset's value, you'll get 10 different answers. But the mean estimate is far more reliable for making decisions about future cash flows from that asset than any other amount based on past costs and allocations.
In most endeavors, quality improves with effort and experience. We think that bringing market values prominently into financial reporting provides a huge opportunity for the appraisal industry. There could be a crush of new business, but a competitive demand for higher-quality appraisals as well. Our bet is that competition by those who render these services would continually raise the bar and produce more precise results. Nothing stirs creative energy in the U.S. economy like an unfilled demand for a product or service.
THE WATERSHED
Here is the watershed issue: Is financial reporting supposed to serve users, or to cater to the mistaken beliefs of preparers and auditors?
If you hold to the former, you will welcome new practices that will reveal volatility, and thus, among other things, encourage managers to take economic steps to actually reduce, instead of using, bad accounting to support the pretense that it isn't there. And if you hold to the latter view, we suggest that your thinking is not only outmoded, but has never had a valid leg to stand on from its beginnings.
It's well past time for a new paradigm on what matters, and the direction of that shift could not be more clear.
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 authors' views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.
