The October issue of Accounting Today included editor Daniel Hood's gleanings from comments offered by leaders in accounting on key issues in the 21st century. One area that jumped out to us was "Relevance," specifically the question of whether the profession is positioned to provide services that are demanded in the economy.
- Rick Telberg says: "The profession as a whole ... in public practice and in industry, teeters on the brink of competitive irrelevancy and irreversible obsolescence."
- Sharada Bhansali raises an alarm by saying, "The profession is losing its relevance and many accountants have settled for this compromising situation."
- Tommye Barie proclaims, "CPAs risk losing relevance in the marketplace without ensuring our services provide value in a timely and meaningful manner."
- Ron Baker asserts, "Unless our profession continuously innovates and adds value, we deserve irrelevancy," and adds this challenging question: "What was the last innovation from the profession?"
We absorbed these comments in light of ideas described by Peter Thiel and Blake Masters in their recent book Zero to One that explains and encourages radical innovation. In our eyes, the fact that none of the profession's efforts to innovate have been revolutionary means that it may already be irrelevant. We explore this possibility by applying their ideas to financial reporting.
ZERO TO ONE?
A co-founder of PayPal and one of the most important futurists in the U.S today, Thiel assesses whether interviewees have the potential to work passionately at innovating by asking them, "What important truth do very few people agree with you on?" When he says "very few people," he means a really small number because he believes real innovation is unlikely without a unique perspective on truth different from the status quo.
His own view is, well, innovative, because it involves two kinds of progress. He calls one of them "horizontal," by which he means new things only improve on previously existing old things, such as electric typewriters replacing manuals, and spinning type balls superseding type bars. He characterizes this progress as "one to n."
Another example is globalization, which Thiel says has merely tried to replicate what worked in the U.S. in the 19th and 20th centuries. He observes that it's just not possible to recreate American lifestyles in countries with less real estate and more people crammed into small spaces.
In contrast, he uses the terms "vertical" and "zero to one" to describe those innovations that have the greatest potential for progress because they are more likely to create revolution, instead of evolution. One example is word processing, because it didn't merely improve typewriters but virtually eliminated them, while significantly changing the way ideas are expressed and conveyed in text.
We observe another case in the move from passenger trains to airplanes. For decades, the railroads kept improving their services but seemingly failed to comprehend how much faster airlines could move their customers. Although some still travel long distance by rail, their numbers are small and the fares must be subsidized.
Notably, innovation and progress are never automatic. Those who strive to achieve them must be courageous and willing to do tough work in the face of opposition and ridicule.
So what do these ideas mean for financial accountants? We think this viewpoint supports our long-held position that financial reporting has been largely stagnant over the last hundred years.
Basically, we fear accountants have plodded along horizontally without significantly improving financial reporting's impact on capital markets, economies, and eventually society itself. Sure, they've embraced new data processing technologies, but they have applied them only to doing the same things they've always done.
For examples, consider cost-based depreciation, financial statement structures, and reporting frequency. We think the only improvement that technology has accomplished is helping accountants compile their outmoded messages more quickly with less effort. Even though the statements are cheaper to prepare and distribute, their content is stuck in a 20th century time warp. For example:
- Spreadsheets and other software calculate cost-based depreciation amounts faster with greater numeric accuracy, but nobody reports actually useful asset values derived from real observations in the place of those meaningless calculated numbers based on biased assumptions and predictions.
- Account balances are still classified on balance sheets as current and noncurrent using criteria that originated who knows when in the dark past, instead of being improved by presenting more details about the anticipated timing of future cash flows.
- Despite users' expressed desires for the direct format, managers publish cash flow statements in the indirect format that ingenious analysts cobbled together in the 1930s to overcome the statement's absence.
- Sophisticated computer systems produce public financial statements once every three months - exactly the same frequency that came into common practice in the 1930s when so-called "electronic brains" were only the wild dreams of science fiction writers.
- The SEC touts XBRL without tapping into its full potential because it is used to tag outdated and otherwise irrelevant data produced by applying pitifully old and obsolete principles.
THE MESS WE'RE IN
We like Thiel's thinking because it meshes with an idea we've advocated since the 1990s. To use his terms, we assert that the only way to achieve vertical innovation and zero to one progress in financial reporting is to completely alter the paradigm applied by practitioners.
In particular, the dominant force that has shaped practice is the drive to satisfy the needs of information providers, primarily managers, their accountants, and their auditors. Under this old paradigm, the crucial questions are:
- "How much does it cost to prepare these reports?" and,
- "How good (or bad) do they make management look?"
The truth the two of us embrace that very few others have comprehended is that financial reporting should instead be shaped by answers to this straightforward question: "What information do report users need to have?"
Once that paradigm is embraced, most everything accountants do will change for the better.
For one thing, conflicts between preparers and users will be drastically reduced. Right now, it seems managers are always looking for ways to coax users into believing what isn't completely true by reporting the least they have to, spinning things to look better than they are, and obscuring any bad news.
What they ignore is the fact that users always wonder what, if anything, in the reports they can safely believe and act on, and what the managers are not revealing and why they don't want users to know about it. The outcome is a communication relationship characterized by suspicion and distrust that inevitably boosts investors' uncertainty and risk to unnecessarily higher levels and thereby increases companies' capital costs.
We believe that this unproductive status quo is rooted in managers' misperception that financial reporting is a zero-sum game that they will somehow lose if they fully inform the capital markets about all their news, both good and bad.
This fear is misdirected because their failure to report the truth, the whole truth, and nothing but the truth always promotes doubt and skepticism. This lack of useful information compels users to search out other indirect and secondary sources (that are also of questionable credibility) to figure out what's wrong in or omitted from the statements, and then go on to invest much time and money to overcome the data deficit.
In other words, everybody loses.
On the other hand, if managers, and their accountants and auditors, were to embrace reporting the complete truth more frequently and (gasp!) clearly, then users would consume the reports with confidence, and experience at least these two benefits:
- They would not have to engage in costly efforts to gather as much information from other sources.
- They would not demand higher returns to compensate for their extra risks.
The result would be investors and creditors who are satisfied with lower returns that in turn decrease the issuing company's capital costs and increase its securities' values.
In addition, managers should find it less stressful to just report the truth without twisting or otherwise massaging their messages. They would also soon discover that truthful information will help them run their companies more productively.
In short, everybody gains.
Of course, some managers would complain about the high cost of reporting more information. In response, we smile and ask them to explain how they can possibly justify the high cost of compiling today's financial statements that contain so much useless information.
TWO STEPS AND A BIG IDEA
As first steps, we propose two innovations: reporting more frequently than quarterly, and basing financial statements on observed current market values, instead of allocated and assumed amounts derived from original and irrelevant costs.
Another idea is universal recognition that financial reporting standards can only establish minimum requirements. Ironically, virtually everyone treats them as defining the maximum that they have to do.
Eventually, astute preparers who realize that users want more information will grasp that they aren't constrained against exceeding the minimums and can voluntarily publish more informative financial reports more frequently.
Besides changing how preparers approach reporting, this big idea would impact how standard-setters and other regulators carry out their responsibilities.
This radical innovation toward serving users' needs would begin to change everything for the better.
However, without it, today's irrelevant financial reporting and auditing (and their practitioners) will be consigned to the future's dustbins, exactly as forecast by the leaders in the introduction to this column.
Paul B. W. Miller is an emeritus 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 or Accounting Today. Reach them at firstname.lastname@example.org.
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