Paul Miller and Paul Bahnson have criticized my op-ed ("It's time to modernize the financial reporting paradigm," Accounting Today, March 19-April 1, 2007, page 14) in their Spirit of Accounting column ("Finding a new wrinkle in smoothing," June 18-July 8, 2007, page 15).In their enthusiasm to lead accounting back to the 19th century, they fail to see our points of agreement and fail to recognize my challenge for a third-way financial reporting paradigm.

At the outset, it's helpful to identify the two currently known financial reporting paradigms. One paradigm is the revenue and expense paradigm of the 20th century, with a focus on measuring net income. Many people, including myself, recognize that this paradigm requires a major overhaul. The other paradigm is the asset and liability paradigm, with a focus on measuring comprehensive income, i.e., the change in net assets.

Many people, including Miller and Bahnson, and major institutions, such as the Financial Accounting Standards Board and the International Accounting Standards Board, advocate this other paradigm as the complete and only solution, but such a singular focus ignores user needs and the lessons of history.

Though Miller, Bahnson and I agree that serving users is the only purpose of financial reporting, we disagree as to who all the users are and what they need. I say that a major user group consists of small investors, and that the small investor needs a net income measurement suitable for price-to-earnings ratio analysis, the most fundamental type of investment analysis. Since comprehensive income includes windfalls (i.e., extraordinary items and capital-value swings), it is not a suitable basis for price-to-earnings ratio analysis. It's not a measurement of what might be termed going-concern-earning-power, permanent, or steady-state income, i.e., net income.

Miller and Bahnson cited the CFA Institute and its membership as being an important user group, which it is. However, it is not the only user group.

Miller and Bahnson charge both "the conventional camp" and me with "decades of entrenched practice," the flawed wisdom of "protecting the users against volatility," and ignoring the facts. Furthermore, they claim a high ground based on their academic training and "common business sense."

But what is the case?

Some recent academic publications have argued for, as Miller and Bahnson wrote, "protecting the users against volatility."

Fischer Black, developer of the famous Black-Scholes options valuation formula in the early 1980s, wrote that everyone wants an income measurement with windfalls removed. George May, who was instrumental in the formation of the Securities and Exchange Commission, wrote to the effect that removing windfalls was the most important objective in providing useful financial reports. Nobel Laureate economist J.R. Hicks, even though he is frequently understood to advocate comprehensive income, actually wrote advocating removing windfalls to yield useful income measurements.

History, too, argues the same point. At the start of the 19th century in both the U.K. and U.S., income was calculated as the change in net assets - what is called comprehensive income today. However, at about the turn of the century, because of a need for a going-concern-earning-power, permanent, or steady-state income measurement, the revenue and expense income paradigm was developed, with its focus on net income. It's because this paradigm has fallen short of its mission that accounting today is in crisis. But this does not mean that the R&E paradigm, let alone its calculation objective, should be jettisoned.

And finally, as regards common business sense, what is the primary question of every investor? Simply: 'What is an investment going to do for me?' Because comprehensive income includes windfalls, it does not answer that question. So "common business sense" suggests a going-concern-earning-power, permanent, or steady-state income, i.e., net income.

Why not recognize that experience with both the R&E and the asset and liability paradigms attests to their inadequacies?

In past decades, criticisms have mounted regarding R&E's inaccuracies in income calculation and positional representation resulting from a historic cost basis. Both the 19th century experience and the writings of Hicks, May and Black all suggest that comprehensive income is a deficient income measurement.

As I challenged in my op-ed, we need to develop a third-way paradigm. Such a paradigm should focus on the fundamental problem with the R&E paradigm: its inability to handle A&L value changes. I wrote, "Pursuant to the comprehensive income paradigm, it should yield balance-sheet entries based upon current market values." Pursuant to the original objective of the revenue and expense paradigm, it should also yield a net income measurement with windfalls removed and that is suitable for price-to-earnings ratio analysis.

I believe that the key to developing a third way is to employ some concepts of differential calculus. Using such concepts, we might calculate what might be termed "instantaneous income" of assets and liabilities, and then be able to separate windfalls from income. My comment letter to FASB regarding their conceptual framework introduces how this might be done, while sparing the practitioner from needing to know calculus. (See www.iasb.org/nr/rdonlyres/fb3b5b32-0214-4737-8613- 54e13a8faf60/0/cl120.pdf.)

Perhaps Miller and Bahnson misunderstood my op-ed as a simple advocacy of the R&E paradigm. They accused me of thinking "that market-based measurement introduces far too much volatility into financial reporting." I'm all for market-based measurements. They accused me of advocating smoothing. I have never advocated smoothing. They accused me of ignoring user interest. I am focused on the user, specifically the small investor as described above.

Finally, they accuse me of being closed-minded. But who is closed-minded?

I fully agree with their last sentence: "It's well past time for a new paradigm on what matters, and the direction of that shift could not be more clear."

Joel Jameson

Founder, Silicon Economics

Cupertino, Calif.

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