The Spirit of Accounting
Our November column used the time-proven Four-Way Test to demonstrate that GAAP financial statements are unethical because they hide truth, lack fairness, don’t build goodwill, and benefit only some people.
Because we would be irresponsible if we didn’t offer a vision for a different system, we’re starting a series of columns that points the best way forward. Specifically, we will discredit numerous myths about market values that have inhibited their acceptance.
This strategy reflects our longstanding frustration that financial statements don’t provide information that helps users make rational decisions by revealing a company’s real net worth and income.
Fasten your seat belt.
To begin, we point out multiple negative effects of not reporting market values in the statements. Investors and creditors who use GAAP statements face immense uncertainty unless they cobble together sufficient additional value-based data to get at useful truth.
Even then, two reasons compel them to demand higher expected returns: They want to recover their costs of searching out that information, and they still face substantial risk from relying on less credible secondary sources.
Managers cannot make sound plans without knowing their assets’ and liabilities’ real values. Regrettably, many are trapped into managing only what gets measured under GAAP without considering other relevant facts. For example, they will flounder if they predict return rates using assets’ book values and net income measures based on systematic depreciation. Further, users’ higher returns create higher capital costs for managers.
Capital markets are inefficient in comparison to how they could operate if they had ready access to market value information about assets, liabilities and real income. Because they’re inefficient without it, the larger economy is less productive and society is less prosperous.
Accountants and auditors shortchange themselves by not serving their internal and external users’ information needs. They would reap more compensation and satisfaction by delivering genuinely useful information, instead of complacently reporting what they’ve always reported, namely the least that’s required.
THE STATUS QUO IS A NO-GO
We know the status quo is not worth protecting and we aim to weaken its grip by establishing these truths:
- Market value information is always relevant.
- Demand for value-based reporting is large and growing.
- That demand will surely stimulate others to create new data sources.
- Managers who ignore market values incur higher capital costs and make poor internal decisions.
- Auditors who contentedly offer their current services will become inconsequential.
- Political resistance to financial reporting progress is self-defeating.
Our thoughts are provocative because we’re contradicting familiar assumptions that accountants have been taught to believe and implement without second thoughts.
For example, many embrace the myth that market values aren’t relevant to anyone’s decisions. Others duck the relevance issue by repeating unfounded claims that there are no practical sources of up-to-date market value information despite unimaginable advances in database technology over just the last few years.
We also observe that managers reject market values because they vainly want to keep secrets from their industry competitors. They’re misguided because they’re ignoring the truth that they’re also competing in capital markets where the absolutely worst strategy is leaving investors and creditors in the dark. The unavoidable outcome is higher capital costs and lower stock valuations.
Auditors shun some market values to avoid the risk of recrimination for attesting to asset amounts that might go down later. We say “some” because they’re willing to attest to market values that are less than book values.
Finally, powerful political contingents staunchly protect cost-based accounting because they want to maintain dominance over the standard-setting process.
Specifically, they fear losing their influence over the Financial Accounting Standards Board if it were to move toward reporting values. It’s obvious that their highest priority is retaining their power, not reporting useful information.
These opponents of value-based accounting all have one thing in common: They supply financial information. To their misfortune, they don’t comprehend that they would thrive financially if they satisfied those who demand useful information. The inevitable result of their stubborn opposition is a spiral into an economic oblivion reserved for those who won’t provide what other people will happily pay for.
Although most suppliers believe their supply-side thinking is supported by good reasons, it isn’t.
One common fallacy asserts that only users benefit from financial statements, while only managers incur reporting costs. In fact, useful information benefits managers by giving them more favorable access to capital markets and supporting more rational internal decisions.
As described earlier, users incur additional costs to augment insufficient public information. Thus, managers who minimize their reporting costs are actually penalized for increasing users’ uncertainty. Because users pass their costs back to managers by imposing higher capital costs and lower stock prices, the latter are worse off by much more than they think they save by not meeting the former’s needs.
An example of shortsighted supply-side thinking occurred in the early 1980s when FASB faced a pivotal question in its conceptual framework project. At issue was whether value-based information is more useful than cost-based information.
A burgeoning board consensus for values was snuffed out by political pressure from the Business Roundtable and the Financial Executives Institute. Ever since, FASB has had to re-debate this issue in virtually all projects. Meanwhile, users who want value-based reports aren’t getting them and higher capital costs are perpetuated.
MARKET VALUE MYTHS
Here are some myths that our columns will debunk:
1. The market value of an asset or liability is a single number.
2. Assets’ original costs (or liabilities’ original proceeds) equal their market values on the date they’re acquired (or incurred).
3. Users don’t want to know market values.
4. Market values for assets (or liabilities) are irrelevant if management doesn’t plan to sell (or settle) them.
5. Market values are unreliable because they’re hypothetical predictions.
6. Market values can be reliably calculated.
7. Market value information is too costly to update.
8. Unrealized losses are real but unrealized gains are not.
9. Market values cannot be safely audited.
10. Reporting market values makes real income volatile.
11. Reporting market values makes stock prices volatile.
12. Existing GAAP are cost-based.
13. Market value information is not useful for private companies.
14. Market value-based financial statements will never be acceptable.
We’ll start by tackling the first two in this column.
DEBUNKING MYTH NO. 1
A few decades ago, this myth crumbled for us when we figured out that market value is not a single point but a population of points.
Our “Aha!” moment came when we realized that a company’s specific transaction is only one of many similar transactions, each with its own price. In turn, all those transactions produce a distribution of executed prices. It follows that information about the distribution is far more useful than information about any individual transaction.
In particular, an array of market values has relevant statistics, including its mean (“expected value”), median, mode, range and deviation around the mean.
The accompanying diagram (see “Price distribution,” below) depicts a distribution of recent prices in an asset market. The horizontal axis represents prices paid for similar purchased assets, while the vertical axis represents the number of transactions at each price. For convenience, we’ve shown a normal distribution where the mean, median and mode prices are all the same. Real situations may vary from this example, but the underlying concepts still apply. (They also apply to liabilities where the horizontal axis represents the cash received in exchange for a promise to make future payments.)
This concept that market value is not a single point may puzzle accountants because they’re accustomed to reporting specific amounts, not distributions. To accommodate them, we suggest that the mean (or a range around the mean) might usefully describe “the” market value. However, it would fall well short of fully describing the situation.
DEBUNKING MYTH NO. 2
These ideas also debunk the second myth that buyers record assets at cost (and liabilities at their proceeds) because those amounts equal their market values.
Because each transaction is but a single point in the population of all the transactions, it’s impossible for each and every one of them to equal the mean value. Instead, buyers with costs to the left of the mean have purchase gains because they paid less than most others. Likewise, buyers with costs to the right of the mean have purchase losses because they paid more than most others.
The managers of TrueCar believe consumers can understand this point because its Web site (www.truecar.com) uses bell curves to describe vehicles’ recent selling prices.
We speculate that the myth that cost equals market value exists because applying it avoids objectionable outcomes for both auditors and clients.
Specifically, auditors don’t want clients to report gains from purchases while clients don’t want to report losses from purchases. When asset purchases are recorded at cost, both parties’ objections go away. However, users get short shrift because the financial statements are incomplete and less useful.
This myth also causes borrowers to recognize new liabilities at amounts equal to their cash (or equivalent) proceeds even when they differ from the debts’ mean market values. Even though they aren’t recorded under GAAP, real gains (or losses) occur when the proceeds are greater (or less) than the mean.
THERE’S MORE TO COME
GAAP financial statements are not ethical. Why not? Because they aren’t useful. Why not? Because they don’t report market values. Why not? Because of myths about them.
We’ve just debunked two myths, with more to come. Watch this space and get on board with the future.
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 email@example.com.