One of our colleagues who regularly teaches continuing education courses around the country tells us that he occasionally gets grilled about us and our columns. He laughingly calls it "guilt by common institution."
Anyway, our recent writings on market values have struck a chord (both harmonious and otherwise) with some of his participants, and he has shared with us a recurring skeptical query that he receives. Specifically, accountants at small companies and small CPA firms have questioned the appropriateness of tracking and reporting market values for these smaller-scale operations.
While they often readily concede that market values may be well and good for large firms, where there is separation between ownership and management, surely in small firms where owners are in control they would not derive the same benefits, right? And don't the costs of finding and compiling the market value information impose a heavier burden on smaller companies, too?
In actuality, we believe that market values are at least as important at smaller-sized businesses. There are several reasons we think so. First of all, market values impose discipline on managers, whether or not they are also owners. All businesses need to generate reasonable returns on the invested capital. If profits based on historical costs are the gauge of success, how does anyone know whether these investments are properly employed? The cost-based rate of return may look ample or even impressive, but it is a misleading performance indicator when the recorded asset and liability amounts are out of date.
Furthermore, if the market-based rate of return on any investment is substandard, then others are deriving better use of their assets than we are. Better for us to sell our assets at market value to one of them and use the proceeds where our return potential is higher. Of course, some may argue that managers who are also owners will not knowingly choose to deploy assets where returns are substandard. Our response wonders how the manager would know without tracking market values.
Our view can be summed up by saying, "You manage what you measure," or "Out of sight and out of mind." If you have to manage with out-of-date information, you respond according to what is reported. If you don't report it, you won't worry about it. It is also why we are so confident that a real economic payoff will come from applying Quality Financial Reporting, our paradigm that embraces market values.
Second, even if a small firm is not publicly held, there may well be absentee owners who aren't involved in day-to-day operations. Wouldn't they be better served with up-to-date information about what's being done with their funds? If they have more complete information, won't they face less risk in their investment and be satisfied with a lower rate of return? Of course, this, too, is another example of the fundamental economics of QFR thinking.
The third issue is related to the second. It has to do with users of financial statements who are neither owners nor managers. From the largest to the smallest company out there, both public and private, surely a bank or two is called on from time to time to help finance operations. Their credit risk is primarily related to overall profitability in comparison to the amount borrowed (e.g., interest coverage); however, risk can also be mitigated by pledging specific assets as collateral.
Of course, collateralizing is wisely accomplished only after estimating the cash contingently realizable from liquidating the asset. Let's see, which amount will help the banker better estimate that amount - historical cost-based book value or current market value?
Furthermore, if the company does not tell the lender what the current market value is, then the lender will estimate it independently. Being cautious, lenders will customarily pick a lower (conservative) value to protect against the risk created by not knowing for sure.
A common retort (and believe us, we have heard them all) is that lenders are adept at using historical cost amounts to estimate market values. However, even if true, these estimates are neither costless nor risk-free to the lender. The costs incurred may not be visible, but you can be sure that any amounts that the banker spends (directly or indirectly) are ultimately passed along to the borrower. Likewise, risk, whether due to concern about profitability or collateral value, raises interest rates, a direct and visible incremental cost to the borrower that could be avoided by reporting differently.
Now, compare this typical situation to one where the borrower provides its own measures of current market values based on its own direct experience in the markets where the assets are bought and sold. Unless the bankers have reasons to suspect management's integrity, they face less risk, and by now you have heard us say many times that this state of mind translates into a lower cost of capital and a higher enterprise value.
We can't move on without making the point of how ludicrous it is to hope (or expect) that users will not believe the numbers that you report in your financial statements. What does it mean when the worst thing that can happen is that the readers actually believe what you report?
We think this observation shows how much of what passes for financial reporting is really a glorified shell game.
A fourth benefit of value-based accounting involves insurance. How would owner/managers know whether they have adequate coverage if they don't track what their assets are worth? Any who insured only book values, particularly of real estate, would find themselves in a sorry state if they have to use the policy proceeds to recover from a disaster. Because we believe that wise managers already track market values for insurance purposes, then it is only a small step for them to begin reporting these market values in financial statements. In other words, the expense of reporting values is not nearly as great as everyone thinks it is.
All this discussion should not be seen as suggesting that companies, large or small, should fundamentally change their published financial statements. Generally accepted accounting principles do not permit reporting market value throughout the primary financial statements. However, there is no prohibition against providing supplemental market-based information. In fact, SFAS 89 actually encourages companies to provide it, thus bringing value reporting within the circumference of GAAP.
For those who argue that the information would be costly to provide, remember that you've got to spend money to make money. The fundamental principles of QFR show that improving the quality of information results in lower capital costs.
To summarize, there are four reasons for all firms to use market values in their reports:
* It will lead to better management decisions;
* It will allow absentee owners to make more informed decisions;
* It will lead to better lending decisions by creditors; and,
* It really doesn't cost very much anyway.
These reasons provide plenty of motivation for simply grasping the truth that the managers of small companies, just like their counterparts at larger entities, will reap financial benefits from reporting market values.
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.
