We read with interest Alfred King’s recent response to our columns on market values (Accounting Today, May 3-16, 2004). He concedes agreement with some of our basic premises, but the beacon of market value accounting is still only a glow on his horizon. We offer this reply to encourage him and others to set a straighter and faster course in its direction.

Before getting into the details, we want to reiterate our main point — namely, that market values are the future of financial reporting. There can be no clinging to the present state of practice and certainly there can be no turning back.

Mr. King is kind but mistaken when he implies that we created market value accounting. In fact, proposals for its use go back to the 1930s and earlier. In 1985, the Financial Accounting Standards Board issued SFAS 89, which recommends experimenting with market values. We didn’t invent it; we’re just advocating it to encourage the needed reform toward demand-driven financial reporting, the system that we call Quality Financial Reporting.

We agree with him about the challenges of measuring the market values of certain kinds of assets; indeed, we have encouraged experts to tackle them while criticizing others who freeze when they hear “market value” and retreat to historical costs like frightened prairie dogs ducking into their holes. We also note the hypocrisy of those who argue that market values are too unreliable to report, while they embrace asset impairment practices that put market values in financial statements when they’re below historical costs.

Despite Mr. King’s apparent concessions on some of our points, he resists reporting values of assets other than marketable securities because he says that there “is rarely a single price or single value for any specific asset.” While we acknowledge his point that different amounts exist, he overlooks the fact that most of them aren’t suitable for external reporting because they aren’t market values. In short, the measurement issues are not as complex as he suggests, and we see no need to follow him back into the historical cost burrow.

In trying to convince us and others of the dangers lurking in market values, Mr. King hypothesizes a highly specialized asset with a book value of $100,000, a replacement cost (new) of $100,000 plus activation costs of $50,000, a replacement cost (used) of $75,000 plus the same activation costs, and an exit value of $35,000. He asks, “What is its market value?”

He then spends considerable time discussing the uncertainty associated with the asset’s future cash flows, which he describes as dependent on Department of Defense contracts, which, in turn, depend on future congressional actions. In doing so, he seemingly loses track of an important point — namely, that projected future cash flows are too unreliable for financial statements except in certain contractual situations, such as notes and bonds.

In fact, a current market value is often highly reliable because it is a verifiable consensus based on actual, not hypothetical, transactions. To find a market value, you only have to observe what other buyers and sellers are actually exchanging for the same asset or others sufficiently similar to it.

A present value of projected cash flows captures something entirely different. This amount is the asset’s value-in-use, which is an estimated value of the benefits predicted to be derived from using it. Management’s quest is to find and compare assets’ values-in-use and their current market values to decide whether they should be purchased, kept or sold.

It’s possible that King has helped managers estimate values-in-use so often that he is confusing that amount with market value. While we readily grant the difficulty of determining the value-in-use for his example, his stipulated facts show that the market value is easy to find, apparently by looking to actual transactions involving other entities. (It does little good to look at the company’s own past transactions, because they occurred in a different time frame when expectations and the value of the dollar were quite different. Besides, its own transactions are unsuitable for inferring the real value because they are not random and are only single observations.)

Mr. King raises the classic conundrum of whether the market value should be based on replacement cost or exit value. Although this riddle was hotly debated by academics during the 1960s and 1970s, we are now persuaded that reporting either amount (or both) would dramatically increase the quality of information provided to financial statement users. The old debate may be a tempest in a teapot because entry and exit prices tend to converge in even slightly competitive markets, especially when activation costs aren’t material, because the difference reflects only a commission or markup.

As in Mr. King’s example, a sizable difference between entry and exit values reflects the fundamental truth that it would be highly risky to invest in the asset. The large spread simply means that managers would bear a high cost if they change their minds and dispose of this asset soon after buying it.

Thus, any financial statement representation of this asset and operating results will be faithful if and only if it fully reveals this risk. Anyone can see that book value can never describe this risk because systematic depreciation creates nothing more than a fictitious accounting for changes in the asset’s cash flow potential.

Although matching purists would assert that depreciation is supposed to smooth out the cost of using the asset with no concern for usefully representing the asset’s current value, we reject that proposition as irrational. It makes no sense whatsoever to report (and act on) out-of-date past expectations instead of actual current observations.

While managers may feel good reporting these smooth but false results, it is not what sophisticated users want. As reported in an Association for Investment Management and Research monograph, “Financial Reporting in the 1990s and Beyond,” financial analysts, portfolio managers and other investment professionals say, “It is axiomatic that it is better to know what something is worth now than what it was worth at some moment in the past.” Regarding smoothing, the report says, “If there is smoothing to be done, it is the province of the analyst to do it.”

Furthermore, consider what would happen if Mr. King’s imaginary company reported the asset at its exit value of $35,000 shortly after buying it for $150,000, thus producing a sudden charge of $115,000. Wouldn’t the prospect of reporting this loss cause management to think longer and harder before buying the asset? On the other hand, suppose that they could buy another asset for $150,000 with a known exit value of $200,000. Shouldn’t they snatch it up in a hurry?

Under historical cost accounting, management is neither discouraged from buying a machine that promises to drop in value nor encouraged to buy one that promises to increase in value. In fact, these two entirely different situations are reported as if they are exactly equivalent. Here is yet another nail in the coffin for the status quo.

We can’t close without noting that Mr. King placed his imaginary asset’s generally accepted accounting principles book value squarely between the entry and the exit values. What would he propose be done if its book value were to be above both values — say $220,000? GAAP requires that the asset be written down, and we’re wondering which value he would use. Since market value is equally relevant and reliable whether it’s above or below book value, his answer would reveal something about his thinking.

As we have done before, we invite him to cross over the paradigm gap and join us and others who favor progress in financial reporting instead of stagnation and retrogression. The view of the future is much better from this side.


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.

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