We have been writing on the Conceptual Framework in response to the Financial Accounting Standards Board's announced intent to strengthen it. We've discussed the objective of financial reporting, the political situation and its problems, the overarching importance of cash flows, and the nature of relevance and reliability.
We have concluded that the relevant attribute of assets and liabilities is their ability to affect the amount, timing and uncertainty of the entity's future cash flows (AAATUC). Our most recent column described how resolving the issue about which attribute is relevant necessitates assessing the reliability of various methods of estimating its amount.
The task
We don't dispute the fact that AAATUC is an abstract concept, and might seem elusive when it comes to being measured. Despite this obstacle, the task of measuring AAATUC is worth doing, because of the importance of future cash flows (and information about them) to financial statement users.
It is important to understand that AAATUC varies among different assets and liabilities, and that it constantly changes. In particular, AAATUC exists in greater measure when the item can affect future cash flows by causing them to happen sooner and in larger amounts. It also exists in greater measure when the probability of future cash flows is higher. Cash, for example, has a perfect correlation with AAATUC. Receivables have greater AAATUC than inventory because they only need to be collected. Finished goods inventory has greater AAATUC than raw materials because more marketable products have already been produced.
Apart from cash, however, no one can really put their finger on the exact amount of AAATUC. Thus, the quest is for measurement methods that produce results that adequately correlate with its amount at the reporting date. In the following paragraphs, we assess the reliability of most common accounting measurement methods as descriptors of AAATUC.
Past-based measures
For various reasons, including inertia, many traditional accounting measures are rooted in the past. Because of their age, these measures are unlikely to provide reliable descriptions of the entity's contemporary and future ability to generate cash flows. To use FASB's terms, they will not produce faithful representations of AAATUC on the reporting date because they don't reflect existing conditions.
* Original amount. The amount originally paid for an asset (or the original proceeds of a liability) is traditionally given high praise for its verifiability. However, the only thing verifiable is that the original amount was the original amount. Reviewing invoices and other records cannot establish that the amount paid or received actually represents the AAATUC of the asset or liability at the creation date. After all, a record describes only one transaction that was not a random sample among the population of all similar transactions for other firms.
Furthermore, it is preposterous to suggest that the original amount continues to represent AAATUC at any later date. Thus, we reject it as unreliable for describing the current ability to affect cash flows.
* Original market value. It's ironic how often opponents of market values overlook how frequently they are actually used in generally accepted accounting principles. In particular, accounting rules for every business combination compel the buyer to record the acquired assets and liabilities at their market value. Although these amounts may faithfully reflect AAATUC at the acquisition date, they inevitably lose faithfulness as time passes.
For example, demand for Enron shares has declined since 2001, while demand for Apple shares has increased. There is no reason to report their 2001 market value in 2004 financial statements simply because those amounts used to be known with certainty.
* Book value. Relatively few assets and liabilities are actually carried at their original amount. Instead, they are amortized or depreciated according to some anticipated pattern. The book value is never produced with the goal of describing the item's AAATUC.
Indeed, accountants vehemently deny that book values of tangible and intangible assets are anything other than byproducts of allocating their original cost (or market value) to later years. If this process is not even intended to describe AAATUC, then it cannot possibly be expected to produce faithful depictions of that attribute with any regularity.
* Accumulated costs: Manufactured items are presented in the statements at the sum of costs accumulated during production. Cost accounting systems are carefully designed to avoid recognizing the utility (and AAATUC) added by production, even though that result is the whole purpose for the manufacturing process. We discard this method as unfaithful and not neutral.
Future-based methods
Even though GAAP often forces managers to introduce future expectations into accounting measures, these measures are unreliable because they lack verifiability. It is simply impossible to verify the effects of future events until they actually unfold. Although one can go through the shadow process of verifying that management applied reasonable assumptions and methods, that is far different from verifying their faithfulness, which can be accomplished only after the future unfolds.
* Net realizable value, In more than one place in GAAP, management is supposed to predict how much cash will be received from using or selling an asset. The NRV is the simple sum of those future cash flows, and thus reflects only the amount - but not the timing or the uncertainty - of the cash flows. Therefore, it must be dismissed as unfaithful and unverifiable.
* Present value. By discounting future cash flows using a rate that reflects their uncertainty, present value methods produce more faithful estimates of AAATUC than NRV. However, their often speculative nature means that present values are unverifiable and, thus, unreliable. The only justifiable exceptions occur when cash flows are rock-solid contractual amounts that are virtually certain to occur. Even so, the present value approximates the current AAATUC only when the predicted cash flows and the discount rate reflect current conditions, not past.
Present-based methods
We conclude that the only way to reliably describe the current AAATUC of assets and liabilities is to reflect what presently exists, not what used to, or might someday, exist. These contemporary measures are the only potentially faithful representations of AAATUC. With proper safeguards, they can also be verifiable and neutral.
* LOCOM/impaired value. Lower-of-cost-or-market measures have long been embraced by auditors. They remain popular today, as shown by FASB's continued dependence on impairment tests for goodwill and other assets. Nonetheless, they are nothing more than a selective and highly biased use of market values. If market values are sufficiently faithful and verifiable to be reported when they are less than book value, then why would they be otherwise when they are greater? The obvious bias in LOCOM/impairment methods makes them non-neutral and unreliable. We would not mind if they were to be abandoned forthwith.
* Market value. Up to this point, we have discarded every measurement method because it produces unreliable results. Fortunately, this final one, market value, can produce reliable measures of AAATUC when it's done right. The amount can be both neutral and verifiable when it is found by looking to numerous transactions other than just the one that involved the reporting company. The consequence is a measure (if only an average) that reflects the distribution of actual prices paid for similar assets and liabilities by others.
Market value faithfully represents AAATUC, because it tends to be strongly correlated with it. For example, market values rise as an asset has greater ability to produce cash flows more quickly, in larger amounts and with more certainty. Furthermore, current market values are the only measures that produce timely descriptions of AAATUC as of the balance sheet date. (Of course, if values are feasibly obtained at the time of an acquisition or when they're less than book value, they are feasible at all other times, too.)
Our assertion that genuine market values are reliable can be comprehended by grasping that they are facts, based on many real transactions. This point differs from the conventional idea that values are hypothetical amounts that the company would receive or pay if something happened in the future. Those imaginary numbers are indeed unreliable and don't belong in financial accounting, any more than historical costs.
Our conclusion
It's at this point that we are a little frustrated with the space limitations for our column. We have been able to give but a quick glimpse of why we are confident that the only direction for progress lies with abandoning past and future amounts while embracing contemporary reliable market measures. This approach offers hope for providing information that is both relevant and reliable.
We're ready for that kind of innovation, and we'd like to help it get here ASAP.
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
