With the exploding interest in and acceptance for market-value-based information in financial statements, we thought we would rerun a couple of columns from several years back as part of our summer tradition.This one was published in spring 2001, and talks about the hole in generally accepted accounting principles, even value-based GAAP, that continues to insist that there is a difference between unrealized and realized gains and losses. At the heart of this anachronistic practice is confusion between income and cash flows, which are two different things best described in two different financial statements.
Income is the change in equity produced by changes in assets and liabilities. The equity, which is nothing other than the owners' wealth, automatically changes when the value of the assets and liabilities change. This increase or decrease in wealth is as real as it gets. Could it go away as values reverse on another day? Absolutely, but those subsequent events are additional changes in the assets and liabilities and the income of that day. That risk is a fact of life that is not eliminated by not reporting it on the income statement.
On the other hand, realization is nothing but a cash-affecting event that alters the company's exposure to risk by restructuring its assets and liabilities. For example, where there was an investment in stock, there is now cash of equivalent value. Wealth is not changed by the sale, but the risk is altered, a fact that should be reflected on the balance sheet, not the income statement.
Read our analysis and see what you think.
In our trek through GAAP, exposing its limitations, our next stop is investments in marketable securities. Perhaps no other area better demonstrates accountants' reluctance to embrace change if it means abandoning an anachronistic practice that has lost any usefulness it ever had. The specific issue is whether there is any decision-useful difference between realized and unrealized gains and losses.
Presumably, this distinction is rooted in the days when auditors ruled and could indulge their worries that they would be held liable if a client reported investment gains after market values increased but later fell. Of course, auditors didn't hesitate to recognize unrealized losses caused by value decreases. This one-sided defensive posture was codified in Accounting Research Bulletin 30 in 1947.
This practice was defended as conservative, but it was never designed to produce useful information for investors and creditors. Rather, it was created to provide armor for auditors. In fact, the Financial Accounting Standards Board's conceptual framework discredits lower-of-cost-or-market as unreliable, because it introduces bias into the statements.
In the Accounting Principles Board's waning days, it issued an exposure draft that called for reporting all marketable investments at - surprise! - their market value, with the changes reported as income when they occurred. The project was never finished, but was passed to the new FASB, which then issued a similar exposure draft.
However, five members lacked courage and produced SFAS 12, which perpetuated LCM for investments, while introducing the idea that some unrealized losses could be reported on the balance sheet without passing through the income statement. Part of their rationalization for this failure was that a quick fix was needed, but there was no time to resolve the conceptual issue of how to report unrealized income. (To show how things have changed, FASB published the exposure draft in November 1975, held hearings early in December 1975, and then issued the standard before the end of that month.) Of course, they really did resolve the issue by putting unrealized income on the balance sheet.
Jumping ahead some 15 years to 1990, the issues were again before the board. Part of the impetus was a comment by Securities and Exchange Commission chair Richard Breeden that, "Serious consideration must be given to reporting all investment securities at market value." Dutifully, the board issued an exposure draft calling for that approach. The eventual outcome was SFAS 115, which falls short, way short, of what could and should have been done.
Instead of simplifying the process and increasing transparency, the board multiplied complexity and added opacity by creating three portfolios and three different methods of accounting for their contents. The distinctions among them are drawn using intent - things go in the trading portfolio if management intends to sell them "in the near term;" in the held-to-maturity portfolio if management intends to hold debt securities until they mature; and into the available-for-sale portfolio if management has no clue what it is going to do. Thus, the same investment can be owned by three different companies and reported three different ways. The standard fails a reality check and does not provide useful information.
Specifically, it relies on the fossilized idea that selling an investment creates income, while holding it does not. Even if this notion might have been valid in the past, which we doubt, it has no place in today's accounting. Under this old paradigm, income, even huge amounts of income, is "earned" by the mere click of a mouse, because that's all it takes to sell an equity or debt investment. Suppose a company has $185,000 worth of stock before the click. Afterwards, it has $185,000 of cash. While it has more cash, it does not have any more or less wealth.
As everyone surely needs to understand, the income statement is supposed to describe changes in wealth, not cash. The cash-flow statement is supposed to describe changes in cash, not wealth.
Consider a holding purchased in 1997 for $150,000 that was worth $120,000 at the end of that year, $300,000 at the end of 1998, $400,000 at the end of 1999, and only $185,000 when it was sold at the end of 2000.
If it was a trading stock, all those value changes would be reported on the investor's income statements, clearly revealing the risk that management imposed on the stockholders. What a ride their wealth went on, but at least they would have known what was happening.
But if the stock was called available for sale, nothing would be reported on the income statement until 2000, when a $35,000 gain would suddenly materialize, even though the holding's value dropped by $215,000 in that year. What utter nonsense!
The defenders of the status quo might argue that the interim gains and losses should be kept from the income statement because they weren't real. That's barking up the wrong tree - the swings in value are relevant indicators of potential cash flow that the management left unharvested until too late. Why should that reality be kept from the stockholders? The only reason is managers' commitment to looking good in all situations and the board's inability to impose discipline on that narcissism.
To summarize, SFAS 115 causes income to not be reported in years in which it really occurs, and to be reported in a year in which it really does not occur. No one can defend this outcome unless they believe that financial reporting should make management look good, make auditors safe, and keep decision-makers in the dark.
The good news is that the board is again asking whether market-value information about all financial instruments is sufficiently useful to be included in financial statements. Beyond doubt, it is relevant for assessing future cash-flow amounts, timing and uncertainty. The only issue is whether it can be measured reliably.
Of course, that issue is not global for all instruments; rather, each instrument's measurability must be addressed in its specific context. If a particular result is not reliable, the only legitimate reaction is to find a way to adequately increase its reliability. There is no point in retreating to irrelevant original costs that can never be made decision-useful, no matter how carefully their amounts are recalculated.
Unless, of course, you think it is better to deny reality than to confront it.
So, we think these old thoughts are worth putting back into circulation, especially in light of FASB's issuance of SFAS 157 (which guides measurements of market values) and SFAS 159 (which opens up to managers the option of reporting some of their assets and liabilities at market value, with unrealized gains and losses being recognized on the income statement).
Everyone, including managers, accountants, auditors, financial statement users and educators, needs to get up to speed on reporting market values and reality. Our next column will reprise how this frame of mind impacts the virtually unassailed but terribly deficient equity method.
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 firstname.lastname@example.org.
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