Until 1991, the accounting profession was largely guided by historical cost, transaction-based accounting.Granted, fair market value and historical cost at the point of the transaction were deemed equivalent, provided that arm’s-length transactions were involved. However, those making decisions — investors, auditors and regulators — grasped that unless someone gave and accepted consideration for something, its underlying value was arguable.
When all of those familiar with the traditional accounting framework that served economic spheres well through centuries were asked about alternatives, they clamored that fair market value information would be useful in addition to (not instead of) historical cost.
The loss of that invaluable touchstone of historical cost demonstrated through transactions has led to the problematic markets now evident. Pretending that the Information Age had somehow established indisputable market values that could be substituted for actual clearing transactions between unrelated parties set the stage for illusion. Many forewarned that the nature of financial markets entailed tailored instruments with idiosyncratic values for which even thinly traded markets were nonexistent. Those warnings were relatively unheeded or discarded as “solvable” problems.
Today, rather than returning to the touchstone, “let’s pretend” scenarios have fueled the problem. In the traditional pre-1991 setting, those with historical cost investments would view an unstable market and choose to either divest or hold for the long term and weather out the storm. They would distinguish between secondary market movements involving panic, “herd” behavior, speculators and traders, and their own investment position. Yet regulators have made such a strategy untenable by forcing thinly unstable markets to be the basis for recording “fair” value.
I like to use a simple question: If you paid $40,000 for your home, and its value has since ranged between $35,000 to $300,000, and currently sits at $200,000, how do you think about its value and your investment? Do you say that you have lost $100,000 on it, or do you contend that you have made a wise investment that nets you $160,000? What is the relevant number for evaluating your prudence and financial position? Are you tempted to sell your home today, or would you rather postpone such a sale until real estate markets stabilize? Isn’t the real measure of your investment agility tied to when you bought and sold, rather than what markets did in the meantime?
If an understanding of markets is to be achieved, then the touchstone of historical cost and transaction-basis accounting needs to be restored. If, alongside that, one wishes to add a fair market value set of disclosures, that could be informative as well. However, to have displaced the historical cost with fair market value and blurred most distinctions between realized and unrealized gains and losses has been a huge misstep.
WHERE THINGS WENT WRONG
The irony of history is that one can retrace the steps of the process and see with 20-20 hindsight the illogical reasoning for the changes that were made.
The Securities and Exchange Commission, reportedly in light of the savings and loan debacle of the 1980s, initiated the decade’s dialogue to call strongly for fair market value. The linkage was faulty from the start, since the so called “flipping” of real estate among S&Ls was understood at the time to be a distortion of historical cost among related parties. In no sense did it suggest a preference for fair market value; its true lesson was that historical cost must be based on legitimate transactions.
A cynic might ask if other rationales existed for the pressure toward fair market value. For years, the Internal Revenue Service has argued for taxation of fair market value fluctuations. State and local governments have moved toward fair market value basis for property taxes. Regulators and courtrooms have looked to fair market values to measure damages.
Yet now, as the smoke clears, the family businesses and farms forced from their investments by estate taxes have put on the table the question of whether such death taxes should not be eliminated, once and for all. Many state and local governments are discussing capping fair values, establishing exemptions, and otherwise managing the problem of many people facing the loss of their homes due to the tax escalation tied to fair value.
The courts’ class-action damages have removed dollars from one group of shareholders, shifting them to another group, with loss of enormous numbers to the legal process, with little attention to the underlying actual investments or eventual financial position.
Today, the internally inconsistent assertions that fly around the political arena stem from the lack of a reliable touchstone or the refusal to see the elephant in the room. Everyone understands that actual transactions occur that can be logged and evaluated to derive financial position.
For example, we can look at the actual tax collections under different tax regimes. We can assess the volume of transactions that occur as an indicator of the breadth of activity in a market. Graphs of market values over extensive time frames will show ebb and flow, and cycles that suggest that never-ending increases are unlikely. Finally, we can watch how interest rates interplay not merely with lending but with savings.
The transaction basis of yesteryear has been argued to be largely irrelevant due to the prevalence of multi-party exchanges and the advent of pools and portfolios from hedge funds to securitizations, variable-interest entities, structured investment vehicles and almost every imaginable form of derivative instrument. The truth is just the opposite. It is losing sight of transactions that blurs the vision of fiduciary accountability and prudence.
Once again, we can look at the 1990s and this decade to date to see the ingredients of the problem. As banks and investment bankers blurred in product line and incentive, as profits were forced to be back-ended if not sold immediately into the market, and as hedging estimates and soft numbers displaced real transactions, responsibility became blurred and short-term focus became locked into decision-making. As others have sagely pointed out, marketing displaced stewardship.
Success still requires long-term thinking. Those who jump on bandwagons ill-informed are the first to fall on their sword as mirages disappear and actual transactions sort out real financial positions. What is needed is not to let the form of a transaction wipe out its substance.
No matter how many parties are involved, how long one holds the instrument, or how complex the risk-sharing, decision-makers must understand their role in the transaction with transparency. If transactions, rather than fair market values from secondary markets and modeling, were the touchstone, many of the uncertainties claimed today to have been unanticipated would have been evaluated.
Much of the debate on standard-setters’ and regulators’ relative roles and the transparency of economic activity via accounting reporting practices would become secondary if the touchstone were restored. By dual reporting of historical cost on a transaction basis, alongside fair market value estimates, economic entities would make transparent their actual investment, and the distinction between what they have done and what others do in the marketplace.
Board members are in a position to initiate voluntary disclosures that bring the touchstone back into focus. Such action would encourage longer-term focus and better control of investment, financing and operating activities. As the debates heat up among the Financial Accounting Standards Board, the International Accounting Standards Board, the SEC, and others’ preferences in recording complex transactions with varying fair value approaches, economic entities’ leadership can follow the bright light of centuries: historical cost and transaction basis.
Wanda A. Wallace, Ph.D, is the John N. Dalton Professor of Business Emerita at the College of William and Mary, and author of Mastery of the Financial Accounting Research System Through Cases, 2nd Ed. (John Wiley & Sons).
