The Spirit of Accounting: It's time for a market survey on GAAP

A few years back, we developed an informal market survey for financial reporting as an ice-breaker for after-dinner speeches and continuing education seminars. It's nothing fancy, but it is an attention-getter, and goodness knows, financial reporting quality certainly needs a lot of that. Before sharing it with you, we want to provide a little more background on marketing fundamentals.

SETTING THE SCENE

If you have a product you want to bring to market or perhaps an old one that's grown a bit dog-eared and needs revitalization, lots of issues should be identified and resolved. One absolutely essential step is assessing the potential demand. It's senseless trying to sell something that nobody will buy because it does not meet their needs. Yet history shows time and time again that some people get so convinced that their product idea is so great that they don't really need to bother with market research.

A tempting but always disastrous idea is to ignore demand and focus on supply issues like ease of fabrication and costs of labor, material and overhead. The pitfall of this approach is that you may wind up being a cost-competitive producer of something nobody wants to buy.

It doesn't happen only in commercial settings.

Paul Miller was involved in a long-ago effort to develop a five-year accounting program at the University of Utah. The team worked hard, developing all the right documents and getting all the courses approved. Support was essentially unanimous. Only one thing was overlooked, and that was the fact that students wanted to graduate and start earning a salary, instead of staying in school an extra year. Enrollments were minuscule.

Not to be deterred, certain faculty launched the ultimate weapon - they lobbied the state legislature to require five years of education before taking the CPA Exam, and the rest is history for Utah and eventually the nation. Two things should be noted in this example: the flaw of failing to consider the wants and needs of those who consume goods and services, and the capacity of regulation to create phantom demand where it doesn't naturally exist.

WHY IS DEMAND IMPORTANT?

Most of the economic world has shifted to demand-driven thinking, due in no small part to the success of the Total Quality Management movement of the 1980s and 1990s. Under the old paradigm, economic activity was driven by "supply-push" thinking, exemplified by Henry Ford's iconic phrase, "They can have any color they want, as long as it's black."

TQM shifted the impetus to the other side, creating "demand-pull" concepts. Under this paradigm, suppliers put on their customers' skin to find out what they want and need to buy. Among this approach's advantages are better sales and much less wasted effort and money chasing after dumb ideas. Of course, it's still important to control manufacturing costs, but not to the point of failing to serve demand.

Thus, we embrace the idea that financial reporting should be shaped by demand-driven thinking to provide what statement users need and want. In contrast to the rest of the economic world, financial reporting is pretty much the same as it's always been, basically stagnant, with occasional stirrings of the pot, but never a thought given to throwing out the old and starting over again. A new paradigm is needed, and our simple survey helps prove that point.

THE SURVEY

Our icebreaker asks the audience these questions about financial reporting:

1. Would you like reported earnings to be calculated with standards that are (a) biased to produce higher numbers, or (b) designed to describe what really happened?

2. Would you like the balance sheet to (a) omit some liabilities, or (b) include them all?

3. Would you like a company's auditors to be (a) understanding of management's needs and willing to help out, or (b) focused on getting useful information into statement users' hands, even if they have to be tough with their clients?

4. Would you like statements to be published (a) once a quarter, or (b) more frequently?

5. Would you prefer that income results be (a) smoothed and normalized to remove volatility before they're published, or (b) reported as they occur and leave it to users to decide whether and how to smooth or normalize them?

The real power behind these questions emerges when the audience considers them from two distinct perspectives. First, we ask them to assume that they are managers or, by extension, their auditors. Our experience shows that they pick the (a) answers in virtually every case.

We then ask them to assume that they're financial analysts who have to make some future cash-flow projections. When they do, they always pick the (b) answers.

THERE YOU HAVE IT

As near as we can tell, the dichotomy between those two sets of answers explains the mess we're in, because it reveals the yawning gulf of misunderstanding between managers and statement users. The former want to keep information to themselves, while the latter desperately want to have it. If we were talking about a business that provided any other commodity, GAAP financial reporting would have gone bankrupt years ago for failing to serve its market.

What, then, keeps it going? As in the case of the 150-hour education requirement, the answer is securities laws that require managers to report according to GAAP. In their simplistic way of dealing with that law (under strong encouragement from their attorneys), they don't go a millimeter beyond its minimum requirements. Further, they fight tooth and nail against any effort to raise that minimum to a higher level. They just don't get this simple concept: They will be better off if they serve the needs of those who consume their output.

Another aspect of regulation is that mandatory CPA licensing for auditors grants the accounting profession monopoly power and protects it against competitive threats that might motivate change. Such power inevitably leads to and reinforces dead-end, supply-oriented thinking. In effect, the profession appears to be completely averse to progressive innovation, despite the fact that any commercial activity is doomed to fail if it doesn't improve.

We're confident that current GAAP reporting will eventually be widely recognized as nothing more than a mere compliance exercise in response to the phantom demand created by a political standard-setting process. As we see it, today's GAAP-based system is moribund, surviving on life support. Without the law's protection, it would have become economically irrelevant a long time ago.

AN OPPORTUNITY

As is true everywhere, a big problem for someone is a big opportunity for someone else. The disconnect between financial statement users' needs and what they're provided is an opportunity waiting to be seized by those who want to get wealthy the old-fashioned way - by serving others well.

Just where is all that wealth? It can be found in the lower capital costs and higher stock prices produced by improved financial reporting. The supporting evidence for this linkage is ample and rock-solid. (Because we don't have space here to describe it, we refer those who want to see the evidence to Chapters Eight and Nine of our book, Quality Financial Reporting.)

So what does this mean? Managers who meet the markets' information needs will be greeted with open arms and open pocketbooks. The same response will follow when they provide information more frequently. We recently read about a big company's chief executive who threw a fit when his daily dashboard report wasn't ready when expected. Ironically, this same person probably doesn't stop to think that he's forcing the capital markets to wait 90 days to get some official word on what's happened, and then only through the clouded lens of GAAP.

As for auditors, we're confident that some bright folks in that arena will soon figure out that attesting to the reliability of truly useful information is a far more valuable service than attesting to the fact that financial statements comply with GAAP, which simply means that they can be counted on to conceal the truth.

As for educators, it's about time we wised up as a group and quit teaching the same old stuff over and over again. Repetition doesn't make it right.

We challenge everyone out there to look at that survey and ask, "What's in it for me if I get out front in helping to close this information gap?" We think they will find themselves very well off because they will be the first to tap into the proven idea that serving demand brings more wealth than protecting supply.

As for those who don't comprehend the disconnect between what is supplied and what is demanded, well, we have no comforting words.

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.

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