With all the recent brouhaha over the subprime controversy and claims that mark-to-market accounting contributed to or even caused problems for investors in collateralized debt obligations, lots of people have been commenting on the relative usefulness of original cost and estimated market/fair value.One of the recurring themes raised by the chorus of critics (who shall remain nameless) is that original cost is preferable because it’s more reliable than estimated value.

That longstanding argument is nothing but a myth, and we’re going to play the role of MythBusters, borrowing from the popular Discovery Channel show.

This column and later ones will tackle various propositions put forward in support of cost and attacking value.

THE MYTH

The original cost of an asset is the best and most reliable estimate of its market value at the purchase date.

* Flaw No. 1. Our first reply is, “So what?” Even if original cost were to be a reliable estimate of initial market value (which it is not, as you’ll soon see), that status would be only temporary, and highly so. As soon as the irresistible economic forces of supply and demand shift, even if just a little bit, the fair value of the asset also changes. Before you know it, the ability of that past cost to provide useful information for predicting future cash flows is exhausted.

That ability cannot last more than a year at most, but perhaps not even more than a few months. Why no more than one year? There are two reasons. First, the asset’s value can change a great deal in a short time. Second, before long, compliance with GAAP forces accountants to slice and dice the original cost through allocations, primarily for depreciation and cost accounting.

* Flaw No. 2. The assertion that original cost equals initial market value is based on assumptions, not facts. One premise is that both the buyer and seller are fully informed and equivalently motivated to advance their interests. Other assumptions hold that the seller cannot find anyone willing to pay more, while the buyer cannot find anyone willing to sell for less. Somehow, in the whole wide business world, this magical pair happen to find each other every time a recorded transaction happens. Of course, these assumptions are ludicrous.

* Flaw No. 3. Statistics tell us that it’s unlikely that any single transaction price equals the asset’s market value. (The same is true for liabilities, but for convenience we’ll just refer to assets. However, keep in mind that everybody’s liability is someone else’s asset.)

We start by observing that a market for any particular asset exists only when many buyers and sellers engage in exchange transactions. Because all participants aren’t equally informed or motivated, the exchanges don’t occur at the same amount, even when they happen within a short time frame. Accordingly, a market value is a distribution of outcomes, not a single point that constitutes the one and only value.

It’s key to note that this distribution reflects the fact that some paid more than the average, some paid less, and some paid amounts close to the average. This distribution may be tightly dispersed, as we would expect in efficient markets where everyone is well-informed. However, in many, even most, situations, such efficiency does not exist, and the actual distribution of prices is a bell-shaped curve (see “A sample of samples,” at right).

In these circumstances, it’s convenient (though simplistic) to consider the mean to be the market value because it is the distribution’s expected value (M1). You can think of it as the center point of the distribution. If that picture is a valid description of the market’s outcomes, then many transactions can occur at costs (such as C1, C2 or C3) that are significantly higher or lower than the mean market value, or maybe even close to it.

Every stat student knows the only way anyone can know whether a particular observation is close to or far from the mean of a distribution is by taking a random sample of sufficient size to produce a sample distribution that mimics the population distribution.

Here’s the punch line: When someone asserts that the original cost paid for an asset reliably estimates its market value, they are basing their conclusion on a non-random sample of only one observation! Suppose they paid $30,000 for a vehicle. Can they know with confidence that the price from that transaction equals the mean of all prices paid in similar transactions? Not without drawing a larger sample that doesn’t include the company’s own non-random transaction.

As an analogy, suppose an auditor is faced with confirming a population of several thousand receivables. After a careful search, the auditor picks out only one account and declares, “This one is from my next-door neighbors. I’ll take it home and ask them tonight how much they owe the client.” This non-random sample of one is comparable to using a company’s purchase cost as an estimator of the assets market value. It’s very convenient, but very bad accounting.

In defense of the myth, some may argue that more comfort exists if the purchaser carefully shopped around to find the best deal. While that might be true, skeptical financial statement users are unlikely to believe it and, of course, the point of the argument has to be assuring them that the reported numbers are reliable.

CONCLUSION

Thus, the myth that purchase price reliably estimates market value on the purchase date is ... busted! Assumptions and presumptions do not create reliability; rather, all they do is justify shortcuts and produce half-baked statements.

If this myth is busted, then responsible accountants should wonder how it ever got started. We have our own uncomplicated hypothesis.

Consider what would happen if managers had to report their purchase transactions at market value. Half the time, they would have egg on their faces because they would report losses whenever they paid too much. And half the time, they would report gains because they paid less than market, in which case their auditors would have heartburn from attesting to income even though the assets have not yet been put to productive use. Thus, we speculate that original cost is a comfortable political compromise that prevents management embarrassment and reduces auditors’ risk of retribution.

But can this self-interested behavior be used to justify the accounting profession’s failure to provide statement users with truly reliable descriptions of what happened? Not on your life. However, what has been cemented in the status quo is the misbegotten rationalization that the initial cost always equals original market value.

The consequence is financial statements that help managers avoid looking bad half the time, while making auditors feel safe all the time. Alas, looking after their needs means the statements are not fully informative, creating less efficient markets and depressed security prices because of greater uncertainty about what really happened. Obviously, this cover-up is not defensible, at least not with integrity.

IT ISN’T JUST US

Just so you know it isn’t just us, FASB recently acknowledged this reality when it issued SFAS 141 (Revised) for business combinations. Specifically, the board determined that it is possible for an acquirer to obtain a company by paying less than the aggregated market values of its assets and liabilities. If so, the buyer must record the acquired items at their observed market values and go on to report a bargain purchase gain. We loudly applaud this standard, because it liberates at least one small part of GAAP from the clutches of an ancient self-serving myth.

Come back in following issues to watch us do the same sort of myth-busting for other flawed and longstanding practices and rationalizations.

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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