The Spirit of Accounting: Mythbusters: Values are neither hypothetical nor irrelevant

Continuing a theme, this column is another “Mythbuster” that demonstrates the fallacy behind a couple of longstanding arguments against using values in financial statement reporting.In our prior column, we exploded the myth that an asset’s purchase price is a reliable estimate of its original value. We did this by showing that an asset’s market value is not a single point, but a distribution of amounts observed in a number of actual transactions. Because any particular transaction is a nonrandom sample of only one observation out of a large population, it cannot be relied upon to reflect the asset’s fair value.

SECOND MYTH

The second myth is that current market values are hypothetical numbers that don’t belong in financial statements.

Unfortunately, the first part of this myth was endorsed by FASB in SFAS 157, which states: “Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

This definition characterizes fair value as a hypothetical amount equal to what would be paid or received. However, even this linguistic misstep didn’t stop the board from moving ahead, opening the door for expanded fair value reporting.

Flaw No. 1. This myth’s first flaw is that its adherents are either blatant hypocrites or wild-eyed radicals who would overthrow virtually all existing GAAP. Although the hypocrisy angle isn’t enough to bust the myth, we raise it to shake its supporters’ confidence in the status quo.

If they really believe that being hypothetical disqualifies numbers from being included in statements, then they should favor abandoning these ethereal measures, among others: systematic depreciation and the resulting book values; LIFO and FIFO inventory values and cost of goods sold; goodwill; all contingencies; and annual pension cost based on expected returns, deferred prior service costs, and deferred actuarial gains and losses. In these cases, totally imaginary numbers are audited and published without hesitation. So the hypothetical argument is hypocritical.

As for being wild-eyed radicals, our regular readers know that we may fall into that category ... .

Flaw No. 2. Market values are not hypothetical because they are observed in real transactions. For example, traded securities’ fair values are taken from observed trades. The same can be said for other assets, including real estate. If, for example, land in an area has been bought and sold at $12 a foot in 15 or 20 recent transactions, that statistic is not hypothetical. However, if managers decide the land needs to be reported at $20 a foot so they can qualify for a loan, that number is not just hypothetical, it’s fraudulent. (The same can be said for conjured costs, too.)

To be clear, just calling a fabricated number a market value doesn’t make it one.

In other settings, that claim would be called a lie or even perjury. Such prevarications obviously do not belong in financial statements.

For any who would ask how a financial statement reader can know whether reported market values are real or concocted, we reply that audits should produce this confidence. Alas, traditional audits don’t do that because they focus on verifying whether various past transactions occurred. We assert that it’s more than feasible for real auditors to verify others’ actual market transactions and (gulp!) even make judgments about the reasonableness of valuation models used when markets are thin. Clearly, this new breed of auditors would move beyond conventional footing and ticking. Why should they? Because providing this service would clearly add sufficient new value to financial reports to justify much higher fees.

(As a sidebar, some — such as Gene Flegm in the May 2008 Journal of Accountancy — try to discredit market-based accounting practices by blaming them for Enron. This argument does not hold water. In fact, far more reporting frauds have been committed where values were not even involved. For example, the WorldCom scheme that occurred at about the same time as Enron was based on deceptively capitalized historical costs. The fact is that liars will tell lies, regardless of whether reporting is based on costs or values. Of course, auditors make it easier for them if they don’t maintain their integrity.)

CONCLUSION

The myth that market values are hypothetical is: Busted! In fact, market values are real amounts that real people are paying in real transactions at the reporting date. As a result, they are far more reliable than costs based on single past transactions.

THIRD MYTH

The third myth is that market values are not relevant if the assets aren’t going to be sold.

We’ve heard this myth repeated hundreds of times, usually with a condescending look that says, “Get back into your ivory tower.” Like the other myths, it has two fundamental flaws.

Flaw No. 1. One flaw lies in the premise that values are useful only for describing the cash that could be generated by selling assets. A far better premise is that the purpose for financial reporting is to allow users to assess the amount, timing and uncertainty of future cash flows to the company. Those cash flows may come from disposals, but they are more likely to come from using the assets to generate cash flows.

Either way, no number provides as much useful information about an asset’s cash flow potential as its current fair value. First, fair value is a consensus among many buyers and sellers about that potential. If assets have greater cash-flow potential (larger amounts occurring sooner with less risk), their fair values will be greater than those with lesser potential (smaller amounts occurring later with more risk). Second, that consensus exists now, not at some point in the past. Third, market prices respond quickly to changes in the cash flow-potential.

Thus, even if management has no plans to sell an asset, its fair value helps statement users assess the company’s cash-flow potential far more usefully than any other measure.

Flaw No. 2. The second and interwoven flaw behind this myth is the presumption that management engages in irrational and dysfunctional decision-making. Although that condition surely exists in some situations, there is no good reason to make it a premise undergirding the financial reporting system.

WHAT DO WE MEAN?

An old adage explains that everything is for sale when the price is right. If so, then isn’t management mistaken in establishing that some assets won’t be sold at any price? What nonsense that would be, or is, for that matter. If the price is right, then why not sell, even if it means selling the whole company? It simply is neither responsible nor rational to commit to a strategy without assessing whether higher returns could be produced by selling and investing the proceeds elsewhere.

We also note that using GAAP book values instead of market values in financial reports means managers are not easily held accountable for their results. The tendency to manage only what gets measured means that shareholder wealth may continue committed to a project with specious returns. Consider an asset with a $100 million book value, a $250 million market value and annual returns of $20 million. While a complacent manager may be proud of this 20 percent return on book, the real 8 percent economic return won’t impress investors. Putting this market value truth in the GAAP statements would not only better inform investors, it would motivate managers to do better by holding them to a higher standard.

CONCLUSION

The myth that market values are irrelevant for assets that won’t be sold is: Busted! This debunked argument not only ignores the underlying purpose of financial reporting (helping users assess future cash flows) but also encourages, even perpetuates, poor management analyses and decisions.

LOOKING AHEAD

In upcoming columns, we’ll look at other myths that just won’t fade away, such as: market value accounting makes earnings volatile, and costs should be reported because they’re reliable. You can anticipate that we’ll bust them like overripe watermelons falling from a 20-storey building.

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.