Consider this parable: A chemist, an engineer, and an accountant are marooned on a desert island with many cases of canned food but no way to open them. The chemist proposes leaving the cans in saltwater until they corrode, but his idea is rejected as too time-consuming.

The engineer suggests bashing them with a rock, but the others object that it would contaminate the contents. The accountant then proclaims, “I’ve got the perfect solution!” When pressed, he explains: “First, let’s assume we have a can opener… .”

Our thesis is that financial accounting and reporting are dreadfully flawed in practice because they depend on assumptions instead of observations. We hope that idea will spur discussions and encourage new thoughts in three areas.

In particular, we want to nudge practitioners who seemingly operate on automatic pilot because they keep doing the same things over and over again without fully evaluating the usefulness of the fruit of their labors.

We also encourage standard-setters to adopt a new criterion for assessing the suitability of proposed and old rules. Finally, we challenge our academic colleagues to abandon their rote teaching of standard dogma and start creating and passing on better ideas.

 

Our premises and quest

It’s well settled that the objective of financial reporting is to provide useful information to those who rely on its reports.

Our first premise is that information is that which reduces uncertainty about reality. Our second is that observation is the only valid way to obtain useful information. Our third is that reports based on assumptions present only pseudo-information that feigns usefulness but increases uncertainty instead of reducing it.

Our quest is to show that financial reports can assist their users’ decision-making processes only if they contain information based on observations of relevant things and events. Thus, reports compiled with assumptions are just as useless as the marooned accountant’s imaginary can opener.

 

Observation and info

What users really want to do is reduce their uncertainty about the future. There is, of course, no way they can eliminate it, but they can relieve it in the sense that they’re much more likely to make better predictions about future events if they’re completely informed about the present and how it relates to the past. Therefore, those engaged in financial reporting ought to give users useful information about the present and the past.

They can fulfill this responsibility only by creating a data trail consisting of continuously updated observations and reports about actual events occurring over time. Users will be able to make better predictions if they have these sequential facts instead of a single outdated past fact.

 

Assumptions and pseudo-info
It’s axiomatic that those who rely on financial reports compiled from assumptions can be led astray because their contents consist of preconceived imaginary amounts instead of observed real amounts.

As an analogy, suppose the navigator for an 1830 voyage from Boston to London gave the captain a heading and planned speed, and then kept reporting the vessel’s position every day as if it were on course without ever using a chart and instruments to monitor its actual location. As ludicrous as this behavior is, it mimics systematic depreciation practices used in the U.S. since, well, 1830!

Specifically, when acquired property is placed in service, its cost is recorded under the assumption that it equals the asset’s initial market value.

Next, using assumptions about the asset’s useful life and future salvage (market) value, and another assumption about a pattern of value decreases, depreciation charges are calculated and reported over that assumed life without subsequently observing real facts to see what’s really happened. The virtually guaranteed result is that anyone who relies on this fabricated pseudo-information will have been misled.

Of course, impairment accounting forces occasional (but half-hearted) reality checks to discover some declines in assets’ real values, but it’s as useless as a navigation system that would acknowledge southern deviations from the planned route while ignoring any to the north. In a few words, financial reports that incorporate assumptions aren’t worth a dime for actually reducing uncertainty.

 

What about estimates?

Does this analysis mean there should be no estimates in financial reports? No, it doesn’t, but adherents to the assumption-laden status quo shouldn’t breathe easy.

Engineers and scientists know that essentially all measurement processes produce only estimates of real magnitudes. However, imprecise measures are useful when they’re known (not just assumed) to be sufficiently close to the real amounts.

Significantly, the usefulness of estimates is constrained by a factor other than their precision. That is, a useful estimate must approximate the magnitude of a relevant characteristic of the relevant item.

If, for example, the weight of an instrument to be installed on a satellite is relevant to deciding whether to put it on board, a very precise estimate of its volume won’t be useful.

Because useful financial reports for assessing financial position and income should contain continuously re-estimated current market values, precisely calculated depreciated book values will never fill the bill because they’re based on assumptions. It would be pointless to develop more precise predictions of service lives and salvage values because they would still be assumed.

Bottom line, systematic allocations can produce nothing but misleading pseudo-information. Therefore, useful information will be produced only if observed market values are reported, even when they have to be estimated, as we describe in a moment.


What about timeliness?

The results of observations can be useful if and only if they reflect current situations.

Suppose the ship captain asked the navigator for their current position three days into the voyage and was told, “We were in Boston Harbor when we left.” This accurate but untimely observation is totally useless.

In the same way, financial reports that describe assets, liabilities and related income items only in terms of past costs are not directly useful or otherwise helpful for even guessing current conditions and income. They’re actually not much better than nothing for predicting the future.

 

What about verification?

A perennial but ineffective defense for historical cost-based measures asserts: “At least an asset’s initial value is based on an observed and verifiable transaction.” This universally embraced mantra is embedded in accounting textbooks and typically absorbed without any critical analysis.

The catch is that it is totally fallacious because it assumes (there’s that word again) that this particular transaction is representative of all purchases of similar assets.

Suppose the five of clubs comes up when cutting a deck of cards with an unknown composition. Although we could absolutely verify the cut produced the five of clubs, would it make sense to assume that every other card in the deck is also a five of clubs? A five? A club? A black card? No! The only known fact is that this particular cut produced a five of clubs. We need a much larger sample to infer anything about the deck’s actual composition.

When it comes to describing the market value of an acquired asset, its cost is only the amount sacrificed in a single isolated transaction.

Only pseudo-information results from assuming it automatically equals the asset’s real value in the broader marketplace.

Valid information about its value can be obtained only by observing a larger sample of prices other buyers recently paid for similar assets.

This analysis shows that auditing an asset’s acquisition cost will not — indeed cannot — provide useful information about its real value. That’s true even at the purchase date and indisputably true for later reporting dates.

Similarly, it’s pointless to audit service lives and salvage values because pseudo-information can never be made useful. Verification is worthwhile only for observations of relevant facts.

 

Assumptions in accounting

Consider these few examples in GAAP (among many more) where assumptions shape reported results:

  • Inventory — physical flows are assumed.
  • Investments — valuations and income are assumed to be affected by management’s intent and the percentage owned.
  • Goodwill — the difference between total cost and the identifiable assets’ value is assumed to equal goodwill’s real value.
  • Operating leases — it’s assumed that the lessee has no asset or liability.
  • Liabilities — original discount rates are assumed to still be effective.
  • Defined-benefit pensions — income smoothing practices reflect the assumption that users don’t need to know about year-to-year volatility.
  • Stock options — it’s assumed that the options’ grant date value is the maximum compensation cost.
  • Earnings per share — the farcical “treasury stock” method applied to dilutive options is but one of many assumptions underlying EPS calculations.

Perhaps the most preposterous assumption assumes that users don’t care that accountants make assumptions.
 

FASB fumbles

We’ll close by spotlighting the Financial Accounting Standards Board’s unfortunate lapse when it defined an asset’s fair value in SFAS 157 as the amount that would be received from selling it.

This definition is actually unworkable because it forces accountants to speculate about and somehow measure a future event that hasn’t happened. It can fabricate nothing but pseudo-information.

Instead, suppose FASB had defined fair value as the amount that other sellers have actually received in recent transactions. That value could be estimated by finding an average of a distribution of observed results for a representative sample of such transactions, This mean value (and the data points) are useful because they’re observed, relevant, timely and verifiable facts, not assumptions.

This shortcoming suggests that even experts can grow so accustomed to relying on assumptions that they don’t realize they’re making them.

 

Our ultimate desired outcome

We aim to shake the foundations of financial reporting practice and we hope this
analysis helps.

Our ultimate desired outcome is that accountants will stop assuming and start observing so they can have a more significant positive impact on society’s well-being.

And their own.

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.

Register or login for access to this item and much more

All Accounting Today content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access