In our column last month, we described Peter Thiel's concept of "Zero to One" innovation that aims to significantly alter the way things are done, as contrasted with "One to N" innovation that merely tweaks the status quo.

We explained that the key to achieving "Zero to One" innovation in financial reporting is switching paradigms so that the interests of information users are definitively promoted over those pursued by information suppliers. As a forerunner, many managers adopted the Total Quality Management mindset that comprehends the value created by fully understanding and then meeting their customers' needs. They moved to that paradigm only after they stopped focusing on what was most economical for them to build and deliver.

Alas, practitioners and standard-setters still stew and fret about the cost of providing financial reports, thus revealing that a "preparers-first" attitude remains dominant in financial reporting. Instead, they should pursue ways to make the statements more useful because their increased value will overwhelm any new preparation costs

This column applies this user-oriented paradigm to explain how the Financial Accounting Standards Board's Private Company Council can and ought to take a different approach to its task of improving financial reporting for non-public companies.

 

SIMPLE? EASY?

As we considered the PCC's activities, we observed a theme in summaries of its recent recommendations presented on a Web site managed by PwC (emphasis added):

  • "This standard provides private companies with an accounting alternative which is intended to simplify the accounting and reporting for goodwill."
  • "This standard provides private companies that are not financial institutions with an accounting alternative which is intended to make it easier for certain interest rate swaps to qualify for hedge accounting."
  • "Under this standard, private companies can elect an exemption from the variable interest entity consolidation model applicable to certain common control leasing arrangements when a specific set of criteria are met."

We hope you notice how the words "simplify," "easier" and "exemption" signal that the PCC is simplifying the financial reports' preparation process when it should be amplifying their contents' usefulness.
 

DISCOVERING USERS' NEEDS

Should the accounting profession commit to providing actually useful information, instead of easy and cheap information, its members will start figuring out what users need to support their decisions.

We'll pause and point out that discovering users' needs is not the same as discovering what they want. While the latter would be a good first step, it's likely they'll say they want what they're already getting with some fine tuning. Creating "Zero to One" innovation requires digging deeper.

As an analogy, we doubt that any expert typists surveyed in the 1970s expressed the desire to enter text into a computer so they could edit and manipulate it on a screen. Nonetheless, when word processing became available, it was embraced and the old typewriter-oriented paradigm was rejected.

Our point is that the starting place for true innovation and progress in private company accounting is identifying what financial information would serve users' true needs. The best way to do that is to look beyond what's already being done.

 

WHAT WOULD BE USEFUL?

We're absolutely certain the search will show that useful private company financial reports should support users' assessments of the reporting firm's creditworthiness and fair value.

In the first case, lenders need comfort on the question of whether they'll be fully repaid by a potential borrower. In turn, they need to know these four things about the applicant company: its cash flows, their sustainability, the cash available from its assets pledged as collateral or through liquidation, and the current value of its existing obligations and commitments.

In the second case, potential buyers need a clear insight into the firm's fair value before they set an asking price. In turn, they need information that unveils these four things about a target company: its cash flows, their sustainability, the market values of its assets, and the market values of its existing obligations and commitments. (In addition, the present owners would benefit greatly from knowing those four things before accepting an offer or proposing a selling price.)

 

SO WHAT?

Our observations reveal two points. First, the same information is useful for both assessments. Second, this information is not provided under existing generally accepted accounting principles for either public or private companies. So, what do these points imply?

For example, suppose a private company's owners apply for a loan and present the banker with financial statements to support the application. If they complied with GAAP, the operating cash flows would not be intelligibly described, earnings would be computed using systematically allocated original costs, assets would be reported at cost minus accumulated depreciation, and liabilities would be presented at book values equal to their present values discounted at their original market rates.

Now, suppose a potential buyer is pursuing a friendly acquisition and wants to develop a fair offering price. Once due diligence begins, the buyer would gain access to the company's GAAP financial statements that don't provide the needed information.

Here is the key observation: The last thing the owners would want the bankers and buyers to do is use the GAAP financial statements to support their assessments of creditworthiness and firm value! Why? Because users are left without the useful information they need, their resulting uncertainty and risk exert upward pressure on interest rates and downward pressure on purchase offers.

As of now, private-company owners can try to overcome these negative effects only by voluntarily providing useful information through extensive non-GAAP disclosures.

 

DOING BETTER

So, what does it say about the quality of today's GAAP statements if the best advice to their issuers is that they shouldn't depend on them to tell their story, and the best advice to their users is that they shouldn't rely on them to support their decisions?

As ludicrous as it seems, that situation is exactly what exists today. Therefore, achieving true progress means that private-company accounting must pursue a drastically different objective. We think it's clear that simplifying the preparation process is going in absolutely the wrong direction.

Thus, these major reforms are essential for making financial statements useful:

1. The cash flow statement should use the direct method and be restructured to report, for example, interest payments as financing outflows.

2. The income statement's numbers should be based on observations of real events, specifically changes (up and down) in the values of all assets and liabilities, instead of hypothetical assumed depreciation costs based on biased predictions uttered long ago and allocated interest costs based on ancient rates.

3. The balance sheet should report all assets and liabilities at their market values.

Those changes would begin to amplify the financial statements' usefulness and, for all we know, they may very well simplify the preparation process at the same time.

 

BUT, BUT, BUT ...

We can hear the sputtering -- "But, but, but ... those changes would drive up the cost of producing the statements. Besides, we don't know how to do the direct method or estimate market values for assets and liabilities." We also know that auditors will deny that they can audit these statements.

Again, so what? To return to our earlier example, word processors initially cost far more than typewriters but certainly delivered far more value. Fortunately, they were designed and built by visionaries who were certain of that outcome and didn't worry about the price point. Once this technology came to market, it was bought by millions who incurred higher costs because they understood how much value they were getting.

We're sure that most who are committed to a status quo always deny that the old way is finished and rebuff any thought of embracing a new way. (As an exception, the managers at Keuffel & Esser, the maker of top-quality slide rules, did not go into denial but laudably exited that business as soon as pocket calculators like the HP-35 became available.)

Fortunately for accountants and auditors, our proposed reporting practices are already within their grasp. Specifically, the direct method can be implemented by initially coding every cash transaction to identify its cash flow category. In addition, accountants comfortably measure and use market values when assessing whether impairments have occurred and when recording individual assets and liabilities acquired in combinations.

Of course, auditors have successfully audited those market values for years.

We suggest that resisting these advances in financial reporting is not logical but psychological. Specifically, we observe that many accountants suffer from chronic progressaphobia that started when their instructors indoctrinated them with these two dogmas:

  • The easy way is the better way; and,
  • Market values are always bad -- unless they are lower than book value, in which case they are good.

Like any phobia, fear of progress can be overcome only when its victims want to be cured, which is likely if and when they grasp that they'll be better off. As we described last month, those who reject treatment are destined to become irrelevant.
 

TO THE PCC, AND BEYOND!

We urge our friends on the PCC to take private company accounting in the fundamentally different direction of greater usefulness, instead of making it easier for progressaphobic accountants to comply with GAAP. We invite the council members to be open to the new paradigm that puts the highest priority on providing useful information without allowing anything else to overshadow that goal.

Of course, if the PCC can make the switch for private companies, there's no reason FASB can't do the same for public companies as well.

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 paulandpaul@qfr.biz.

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