We’re not sure if we’re having another epiphany, or merely looking at the world a little bit differently, but we have some thoughts on an area of accounting practice and theory that we’d like to share with you.Specifically, we’re looking deeper at the worthiness of comparability as a goal for financial reporting information. As we described in a recent column questioning the wisdom of merging all standard-setting authority in one body, it has been traditionally assumed that useful information helps users compare competing investment opportunities. Think of this notion of comparability as Company A and Company B balanced on a seesaw, suggesting that the investor’s decision is between buying one company’s stock or the other’s.
Although this idea has significantly shaped accounting thought for decades, we think it’s time to supplant it with something else.
TRADITIONAL COMPARABILITY
The Financial Accounting Standards Board’s Conceptual Framework includes comparability as a qualitative characteristic of useful information, and defines it as “the quality of information that enables users to identify similarities in and differences between two sets of economic phenomena.”
SFAC 2 comments on comparability with these words: “Information about an enterprise gains greatly in usefulness if it can be compared with similar information about other enterprises and with similar information about the same enterprise for some other period or some other point in time” (Par. 111). The board attributes great importance to comparability when it also says: “The difficulty in making financial comparisons among enterprises be- cause of the use of different accounting methods has been accepted for many years as the principal reason for the development of accounting standards” (Par. 112).
This connection to standard-setting is, we think, important, because history shows that the quest for comparability has been twisted to become satisfaction with uniformity, which is something quite different.
Uniformity is the condition in which everyone applies the same rules to the same transactions and events. Uniformity brings about comparability if and only if the uniformly applied rule actually produces relevant and reliable information.
For example, most everyone uses straight-line depreciation for their tangible assets. For another, most everyone accounts for non-controlling investments in subsidiaries using the equity method. For still another, everyone now accounts for stock-option expense by spreading the options’ grant-date value over the vesting period. And yet another example is the tortured set of procedures mandated by FASB for defined-benefit pension and OPEB plans.
The fact is, however, that these accounting methods do not provide relevant or reliable information that users need for predicting future cash flows from the company. As a result, usefulness and comparability do not follow from uniformly applying these principles.
So, what explains GAAP’s long-standing emphasis on uniformity? We think it appeals to managers and auditors. It’s much easier to prepare and audit information the same way as everyone else than to implement unique reporting practices that reveal more about future cash flow prospects. Because managers and auditors have long had great political influence over the standard-setting process, it doesn’t surprise us that the rules reflect their interests, and not those of users.
MODERN COMPARABILITY
Instead of presuming that users are asking, “Should we invest in Company A or Company B?” financial reporting needs to catch up to the idea that investors actually are (or should be) asking this question: “Should we invest in Company A or not?” As we see it, they’re going through the list of possible investments one company at a time, not in pairs. If so, they’re not looking at two balance sheets or income statements and converting their reported measures to the same basis, such as getting them both on FIFO, so they can be compared against each other.
Instead of balancing Company A and Company B on the seesaw, investors are really comparing their estimate of a single security’s intrinsic value with its market value.
Intrinsic value is an economic concept that represents the security’s true value. It is elusive and hard to assess because it’s always changing as the enterprise and its environment change. Economists and finance theorists often say that intrinsic value is the present value of the future cash flows discounted at the rate that most completely reflects underlying risk.
What investors are searching for is an imbalance between a security’s current intrinsic and market values. It doesn’t matter which way the imbalance tilts — a profit can be made because the capital markets will sooner or later close the gap between the two as the consensus market value converges on the intrinsic value. Depending on the direction of this momentary gap, investors decide whether to take short or long positions.
Because securities’ market values can be observed, the investor’s task is to assess intrinsic value, and that process is generally thought to be usefully accomplished when investors (and their analysts) perform a fundamental (as opposed to technical) financial analysis. This activity is the basic rationale for publishing financial reporting information.
Here is our bottom line: Modern financial analysis demands financial reports that support investors’ search for intrinsic values.
SO WHAT?
What this thought reveals to us is that traditional financial reporting practice has probably been oriented on the wrong compass. Rather than trying to force everyone to adopt the same practices, whatever those practices turn out to be, this better role for financial reporting demands that policy makers provide managers with latitude to produce statements that transparently describe their economic circumstances to best support users’ assessments of their securities’ intrinsic values.
Before anyone goes ballistic on us, we are not advocating anarchy in which anything goes. We have more aversion than most to false information in financial reports. Liars and cheats should be both shunned and prosecuted.
What we want to do is liberate honest managers from the shackles that literally force them to lie in their financial statements by, for example, reporting depreciation expense when their assets are appreciating, or R&D expense when their labs are discovering all sorts of good things.
THE FAIR VALUE OPTION
In February 2007, FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities, which allows management the freedom to account for some or all of its financial assets and liabilities at their fair values. But this fair value method wasn’t weakened by traditional compromises. The holding gains and losses are to flow straight to the income statement, whether realized or not. This is serious accounting, and we think it ought to be applied to all assets and liabilities.
Why do we favor it? Because it provides more useful information for comparing intrinsic and market values of a company’s stock. It does so by reducing users’ reliance on their own relatively uninformed estimated fair values of a company’s assets and liabilities. It also reduces their need to roll unrealized gains and losses into reported income out of the equity section where they are awkwardly parked while waiting for irrelevant cash transactions. That cautious practice makes traditional GAAP income statements much less than fully useful.
Furthermore, value-based accounting also contributes to traditional comparability. That happens because it actually tells the truth, the whole truth, and nothing but the truth. It’s unadulterated useful information.
WILL ANYONE DO IT?
We’re hoping some chief executives and chief financial officers get the point that here is a great way to improve the quality of their financial reports by doing what other, less-enlightened managers won’t do — namely, tell the truth.
Further, they can innovate without violating GAAP because of SFAS 159, which is exactly the kind of standard that FASB needs to issue over and over again. By making innovation voluntary, the board encourages progress without compromise and without compulsion. We hope this experiment is a success and that it’s followed by many more.
Paul B. W. Miller is a 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. Reach them at paulandpaul@qfr.biz.
