More on users' demands: reliability and materiality

Several columns back, we wrote about a recent report from the CFA Institute called A Comprehensive Business Reporting Model: Financial Reporting for Investors. This monograph is the long-awaited update of the influential Financial Reporting in the 1990s and Beyond.The new report is authored by a committee comprising a veritable who's who of highly experienced financial analysts, and speaks forthrightly about the highly limited usefulness of current generally accepted accounting principles financial reports. (The full report is available free at http://cfapubs.org/ap/issues/v2005n4/toc.html.)

The report's centerpiece is 12 principles that the analysts propose as a conceptual backbone to replace the status quo. We covered two principles in the earlier column, and we now tackle a couple more.

Before doing so, it's worth a reminder that what you're about to read is not coming from two wild-eyed accounting professors. While we enthusiastically support what it says, we didn't write this report. It was written by real, money-in-the-markets, expert statement users who are frustrated from spending their days unraveling generally accepted accounting principles information and re-engineering it to get a rough idea of what they need to know. These are our profession's customers, and it's time to pay serious attention to what they say.

Here is a brief summary of the two principles that we discussed before: first, putting the focus of reporting on equity investors, and second, the importance of fair value information. On the first point, the report argues that, as residual owners, common shareholders need to assess the positions of all claimants positioned before them, including creditors and those with priority equity positions. Thus, if information is designed to meet the needs of these equity investors, it will, by necessity, contain the information needed by all other claimants. It's a rock-solid claim that establishes users' rights to a central place at the table whenever any discussions take place regarding what financial reporting should and should not be about.

The second principle goes directly to the heart of the information these equity investors want - nothing short of complete fair value financial statements. While applauding the Financial Accounting Standards Board's movement in this direction in recent years, they remind us that "the majority of standards comprising the bulk of current GAAP are not based on fair value principles. Much work remains to be done."

Even though we agree wholeheartedly with the sentiment, we think that "market value" is a more apt moniker for the measures that they and we would like to see included in financial statements.

The group also provides an insightful rebuttal to the shopworn lament that fair (or market) value information brings volatility to the statements. Their response is that "if fair value measurement results in greater volatility, then the measurement has merely unmasked the true economic reality that was already there. Honesty and volatility should not be tradeoffs."

Here is the rundown on two more principles.

* Reliability means more than verifiability. The committee tackles an all-too-common misperception about what reliability means in financial reporting. Simply put, reliability is more than being able to authenticate reported amounts. That information characteristic is better known as verifiability, and it has long been used to justify historical cost-based measures.

According to the monograph, the committee interprets reliability more broadly and, in fact, along the lines of FASB's Conceptual Framework. SFAC 2 defines two essential components of reliability: "Verifiability is a quality that may be demonstrated by securing a high degree of consensus among independent measurers using the same measurement methods. Representational faithfulness ... refers to the correspondence or agreement between the accounting numbers and the resources or events those numbers purport to represent."

The committee sees both ingredients as necessary, and goes on to say that the misplaced emphasis on verifiability has caused much of GAAP to "reflect more of a concern for practicality (what is easiest to do and most easily verified) rather than from consideration of what would constitute the most useful information."

We couldn't agree more, but we would go further.

Specifically, we are convinced that relevant information must help users assess the ability of assets and liabilities to affect the amount, timing and uncertainty of future cash flows. Because of market value's timely incorporation of up-to-date facts about expected cash flows, it is far more representationally faithful to that ability than historical cost-based measures.

In addition, because market values are based on numerous real transactions involving multiple buyers and sellers, they are clearly more verifiable than costs, which are based on only one transaction. Our bottom line is that market values are preferable because they are more reliable than historical costs. We see nothing in the CFAI report that disagrees with this point.

* Materiality from a user's perspective. In explaining their thoughts on materiality, the committee says that "despite statements of regulators, including the Securities and Exchange Commission, company managers and their auditors tend to apply ad hoc rules of thumb when deciding whether certain items are of sufficient size or importance for separate reporting."

Rather than rigid quantitative standards, the committee believes that "materiality assessments should use the [qualitative] standard of whether the item would make a difference to an informed investor ... for example, a relatively small amount might change the trend of an expense category."

Going further, they say that more informed materiality decisions will occur when "related items are considered in total and not individually."

The committee's displeasure with today's materiality decisions illustrates perfectly our frequent complaint about inferior accounting produced by supply-oriented thinking. The committee is expressing an economic demand that materiality judgments be based on their needs, since they are the consumers of the information.

Yet, at the same time, managers and auditors obliviously look at things from what's readily defensible and easy for them to do. Instead of providing what users want, today's managers and auditors are supplying information that meets their own needs. Because that means they rely on rule-based standards, they are mindlessly putting out information that no one wants. In a manner of speaking, it's a one-size-fits-all approach where probably no users' needs are served.

* More on meeting demands. To put the point in macroeconomic terms, today's auditors are being protected against a backlash from dissatisfied customers only because they have a monopoly on attestation. Most auditors probably consider that to be a good thing. But is it? While it provides some insulation for rebuffing inappropriate client (preparer) demands, it also desensitizes auditors to meeting the legitimate demands of their real customers, financial statement users.

Furthermore, while there may be only limited competition from outside the profession's fraying velvet rope, there is great potential for considerably more competitive pressure from within.

Some day soon, a few alert managers and their auditors will wake up to the fact that they can capture a much larger market share if they actually cater to the users' demands, instead of ignoring them.

What's more, the greater competition found these days in all markets may eventually result in outsiders encroaching on what has traditionally been the auditors' domain. The vulnerability can already be seen in the substantial share of business that has been lost in the tax services segment.

Would it hurt the profession to become more demand-oriented? Some will undoubtedly be nervous about "selling out" their integrity if they give in to user demands. Nothing would be further from the truth. It is in no way inconsistent with professional integrity to give users statements based on measurement methods and materiality standards that they want, as long as the truth is told.

And, to look at it another way, it's possible that the auditing profession has been responding to demand for years. The only problem is that it has been the demands from their clients for smooth and otherwise managed earnings and balance sheets. They know how to respond, alright. They just need to learn whom they ought to respond to.

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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