In early August, the Financial Accounting Standards Board asked its constitutents to provide their input regarding four possible agenda items. We favor pursuing radical reform for all four and proffer a more aggressive fifth reform that we addressed in a December 2010 column. What we said then still applies, so we’re giving its ideas an encore.

 

ENCOURAGING FASB

Here’s our take on FASB’s list:

  • Intangible assets: All intangibles, including acquired and internally developed R&D assets, should be reported at fair value. The alternative measures (cost, impaired cost, amortized book value and zero) have absolutely no power for predicting future cash flows.
  • Pensions: These arrangements lose complexity when the components are disaggregated into separate assets and liabilities and marked to market with all changes flowing into income statements. Anything less is a retreat to the tortured politically correct thinking of the 1980s.
  • Liabilities and equity: We support the 2007 Preliminary Views proposal to pare equity down to a simple core of common stockholders’ equity while eliminating unrealized items and classifying everything else as liabilities, including options and preferred stock.
  • Performance reporting: We encourage implementing the 2008 Preliminary Views proposal to reform statement structures to distinguish business and financing activities in terms of their results and the assets and liabilities associated with them. We also plead for mandating the direct method of reporting operating cash flows.

Here’s our proposed addition:

  • Depreciation: It’s well past time to rectify the perennial misbelief that systematic depreciation produces useful information and eliminate its persistent significant contamination of financial statements.

 

THE ELEPHANT

When a big issue (like depreciation) is unaddressed despite its painfully obvious existence, an ironic question ponders why nobody notices the “elephant in the room.” In that vein, we ask:

Why is modern accounting still systematically depreciating assets?

Why do standard-setters and other regulators quibble with less significant issues despite depreciation’s glaring flaws?

As for us, we spell depreciation “duh-preciation” because it’s an obsolete, naive, ignorant, crude, ultra-simplistic, lazy and otherwise unsophisticated response to urgent demands for useful information about productive assets.

 

A BRIEF HISTORY

We discovered A History of Federal Tax Depreciation Policy, by David Brazell, et al., distributed in 1989 by the Treasury Department’s Office of Tax Analysis. It astonishingly states that, “Depreciation accounting, as we recognize it today, began in the 1830s and 1840s,” adding that it was embraced to avoid “[t]he expense of conducting repeated appraisals.” Thus, today’s practice is an expedient based on the technology of 180 years ago!

Brazell reports that duh-preciation gained tax deductibility after a 1909 Supreme Court decision, thus cementing its general acceptability with nary a thought to providing useful information for rational decisions, either at that time or since.

As we like saying: Accounting practice cannot be accused of progressing at a glacial pace; after all, glaciers actually move.

 

SO, WHAT’S THE PROBLEM?

This elephant has two flaws: Annual duh-preciation is based on the false premise that value is always lost and never gained, and it is not observed but calculated by combining a single dubious fact with these three unverifiable predictions:

  • Capitalized cost is a fallacious measure of original value because it’s based on the buyer’s sacrifice, instead of the obtained economic utility. (Even if cost somehow could equal value, it would quickly lose that equality.)
  • Service life cannot be validated until the asset is taken out of service.
  • Salvage value cannot be validated until the asset is sold.
  • The allocation pattern is a speculative conjecture that cannot possibly coincide with actual future value changes.

The conclusion is indisputable: The consequence of combining this premise with these false and literally unknowable factors makes duh-preciation a complete fabrication that has no correlation with any real results of real events. If that conclusion is valid, then accountants are both irrational and irresponsible to report these expedient imaginary numbers as if they are facts.
 

ASSESSING THE DAMAGE

Without doubt, systematic duh-preciation leaves abundant havoc in its wake in the form of contrived numbers that masquerade as useful information. This practice pollutes every reported measure it touches, especially assets, cost of goods sold, operating costs, and, of course, earnings. It also ruins return ratios by putting spurious numbers in both the numerator and denominator.

In light of all the duh-preciation debris strewn throughout the statements, is it any wonder that stock prices and earnings numbers aren’t strongly correlated?

 

EBITDA AS A CANARY

Many financial analysts have long identified these flaws and tried to overcome them with their own woefully incomplete EBITDA descriptions of operating results that delete duh-preciation. Even though virtually all accountants disparage this substitute statistic, the analysts are right to believe that reported income is not fully useful.

Significantly, regulators and standard-setters have failed to understand what’s wrong here. Specifically, we’re convinced that they need to comprehend that EBITDA’s widespread use is a proverbial canary in the accounting coal mine. That is, its prevalence should warn everyone that sophisticated users are desperately seeking new information because they don’t consider reported earnings numbers to be completely useful, even though accountants consider them to be their finest accomplishment.

 

IT ISN’T JUST US

Once upon a time (1965), Professor Sid Davidson was on the Accounting Principles Board when it issued Opinion 6 that endorsed systematic duh-preciation. Although he tried to get fellow board members and others to confront the elephant, as a minority of one, he didn’t want to lose influence on other issues. Thus, he voted for Opinion 6 but only after expressing reservations and laying down a big challenge. Read his words while keeping in mind they were published 51 years ago:

“Mr. Davidson agrees with the statement that at the present time ‘property, plant and equipment should not be written up’ to reflect current costs, but only because he feels that current measurement techniques are inadequate for such restatement. When adequate measurement methods are developed, he believes that both the reporting of operations in the income statement and the valuation of plant in the balance sheet would be improved through the use of current rather than acquisition costs. In the meanwhile, strong efforts should be made to develop the techniques for measuring current costs.” (Emphasis added.)

That plea should humiliate every FASB member over the board’s 43-year history. Despite Sid’s clear description of duh-preciation’s obvious deficiencies, none of them have supported any serious efforts to implement value-based tangible asset measures in both directions.

 

HALF AN ELEPHANT?

Strangely, standard-setters have readily embraced recognizing asset impairments, implying that value decreases are sufficiently reliable to report, but have always rejected recognizing value enhancements, implying they’re too unreliable.

This accounting nonsense is compounded because impairment write-downs are triggered when essentially randomly generated book values exceed observed market values. There is absolutely no rational justification for this one-sided practice. Our political explanation is that standard-setters’ thought processes remain strangled by the auditors’ dysfunctional gut-level paradigm that denies the legitimacy of unrealized gains. They’re seemingly too afraid to say, “Hey, what’s that half-elephant doing in here?”

 

YUCK!

Whenever we bring up these shortcomings, accountants rationalize the status quo with the same 180-year-old excuse that there are no available methods for estimating tangible assets’ market values. This shortsighted excuse is embarrassing! After all, if estimation techniques are readily applied for impairments and combinations, then why not use them everywhere?

We hope readers will now actually see the duh-preciation pachyderm. It’s stinking up the place and needs to be escorted out with resolve and great haste.

 

DUTY CALLS

Our September column (“Non-GAAP reporting: Yes, it’s bad, but it doesn’t have to be”) suggested that the most innovative source of useful supplemental reporting of market values would be truth-loving managers who see the advantages of reform. Until that happens, the ability, responsibility and public duty to promote replacing duh-preciation and impairment accounting with current value-based financial statements lies squarely on the shoulders of the Securities and Exchange Commission and FASB.

Instead of getting things moving toward more useful accounting by replacing duh-preciation, we chide these policymakers for figuratively focusing on small rodents instead of confronting this real problem.

While we applaud FASB’s top four to-do items, it should also elevate this fifth issue’s prominence, confront it, and dispense with this early 19th century expedient.

 

GETTING STARTED

One transitional approach would require supplemental reporting of readily available market values using metrics derived from databases of recent transactions or even insured values. Once again, why can’t managers and auditors just do what they do when accounting for impairments and business combinations?

Some 37 years ago, FASB tried this supplemental approach with SFAS 33 but condemned it to fail through these four politically driven constraints on its perceived usefulness: calling it a limited five-year experiment, applying it to only the largest companies, permitting the use of dubious measures (including general price indexation), and recommending that the results not be audited. Managers then choked the last bit of perceived usefulness out of their disclosures by warning everyone against relying on them.

Despite these limitations, though, sophisticated analysts referred to this information as a “godsend” in Financial Reporting in the 1990s and Beyond.

We think supplemental disclosure needs to be, and can be, done better this time.

 

THE TIME IS NOW

After 180 years, it’s long past time to get real about valuation instead of acting like bogus duh-preciation and impairment numbers are relevant and reliable when they’re neither. Everyone needs to respond to Sid Davidson’s challenge and chase this elephant off to the graveyard where it should have gone long ago.

The same old excuses just won’t do.

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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