About a year ago, we began hearing a clamor that accountants exacerbated the financial debacle by reporting market values in financial statements. In turn, accountants ducked the blame by arguing strongly that the Financial Accounting Standards Board was at fault for requiring investment market values to be reported. These complaints have continued to this day.
CNBC's Larry Kudlow, for example, continues to rail against mark-to-market and call for its elimination. We characterize all these protests as bogus, reflecting a perspective anchored in old premises that may be well accepted, even unchallenged, but that are nonetheless totally disconnected from reality. In contrast, better premises lead to different conclusions about who is at fault. Switching to them would lead to new management strategies and new accounting to support those strategies.
THE OLD PREMISES
Premises are nothing more than fundamental assumptions about the environment that shape conclusions about what is happening and how to fix problems. The invalid complaints about mark-to-market are based on these three:
1. The function of reporting is to manage market responses as evidenced in security prices and their stability over time.
2. Capital market participants believe and act on the contents of GAAP statements.
3. Capital market participants do not believe or act on other sources of information.
These assumptions cause their adherents to make two mistakes: They attribute too much power and influence to GAAP financials, and too little power and influence to other data sources. In effect, they give short shrift to the markets' freedom to do whatever they want with regard to both financial statements and their investing decisions.
We ask the following three questions:
1. Is it wise to attempt to use financial reporting policies to manage capital markets?
2. Is it ethical?
3. Is it even possible?
It's evident that those who blame accountants and accounting standards answer all three with a "Yes." That is, they believe that market-based accounting measures are upsetting a delicate reporting system that enables managers to mislead markets into stability and growth by withholding relevant and reliable information from them.
In contrast, in view of the markets' power to seek their own interests and the futility of managing only one set of messages out of the myriads out there, we think the answer to each question is a resounding "No."
NOT THE CULPRIT
Mark-to-market accounting cannot be blamed for the problems, any more than your television set cannot be blamed for the fact your favorite pro golfer didn't win the Masters.
Can we support this analysis? We certainly can.
As to the charge that value-based reporting is creating volatility, that indictment can be leveled if and only if one assumes that volatile results of risky investments simply don't happen if cost-based financial statements don't report them. In its landmark monograph, Financial Reporting in the 1990s and Beyond, a prestigious committee of the Association of Investment Management and Research (now the CFA Institute) said that better accounting reveals volatility that poor accounting conceals.
Simply put, mark-to-market only displays the volatility that already exists. It's only the messenger. To put it another way, the volatility was created by managers who invested in risky assets; all that mark-to-market does is make the losses known to all, instead of keeping them hidden. Without it, the capital markets would be going crazy trying to guess how bad the losses really are, and discounts would be even deeper.
As for the general longing to provide massaged financial statements that report good news without the bad, that misbegotten hope can rest only on the assumption that the capital markets are easily duped and have access to no other information. Further, if capital markets want fair value information and don't get it from financial statements, do they simply shrug their shoulders and use bad information? We don't think so.
Other evidence for bad premises is the frequent claim that historical costs have reliability, always followed by the conclusion that no other characteristic matters. To put the record straight (again), if costs don't provide insight into future cash flow potential, they are not reliable for making decisions.
In fact, costs don't provide reliable evidence of cash flow potential even at the time they happen. This point can be explained with statistical sampling concepts. Specifically, a non-random sample of one observation cannot provide adequate evidence for describing an entire population. Yet cost adherents assume that a company's purchase price provides reliable information about all similar transactions. Of course, they don't all occur at the same amount, so it's absurd to think that each of them can be a reliable and irrefutable measure of value when it happens. If cost doesn't describe cash flow potential initially, it certainly won't do so later on.
The practice of smoothing results is doubtlessly rooted in the premise that markets depend only on financial statements. It's undeniable that smoothing is sought in GAAP reporting. Consider these examples: straight-line depreciation based on predictions, instead of real observations; relegating unrealized gains and losses to the balance sheet; and using expected returns on pension assets to suggest that equity and debt securities (including subprime CDOs) are no riskier than CDs. Such institutionalized departures from economic reality cannot be justified.
NEW PREMISES
In contrast, we subscribe to the following premises on the basis of much research, experience and, most important, common sense:
1. The function of financial reporting is to promote economic growth and stability through efficient capital markets. It serves this function by helping users to assess the amount, timing and uncertainty of future cash flows. (FASB's first concept statement stated this premise some 30 years ago.)
2. Capital markets rely on GAAP financial statements only to the extent that they contain useful information.
3. Capital markets have access to vast quantities of other information that they use in addition to or instead of GAAP financial statements.
4. Capital markets cannot be managed by manipulating the messages in GAAP financial statements; they cannot be misled for long, if at all, and they cannot be coerced into investment decisions merely by contrived appearances.
5. To the extent that GAAP statements don't coincide with reality as perceived by capital markets, they won't be relied on; further, managers who don't provide useful reports will be neither trusted nor rewarded.
6. The lack of relevant, reliable information leads to uncertainty and risk for investors; their rational response is to discount security prices and create higher capital costs for issuers.
These new premises lead to entirely different conclusions.
LIKE WHAT?
We observe that managers have only two things to offer capital markets: prospects for future cash flows, and information about those prospects. Given the rampant skepticism of market participants and the vast variety of alternative investments, it is nothing short of futile hubris for managers to believe that they can use GAAP financial statements to create false impressions that their cash flow prospects are more valuable than they really are. They would be far wiser to improve both the prospects and the information's usefulness. Working on one without the other is like building a car without an engine, or building an engine without a car - utterly pointless.
Thus, to the extent that complying with new standards led to volatile reported results, especially significant losses, the outcome is positive because the markets can understand more about economic reality. To the extent that other standards hide volatility and the declines, the markets are frustrated and bid security prices lower, not higher.
A WORSE THREAT?
If mark-to-market were eliminated, the delivery of bad news wouldn't be avoided, only postponed. One thing we learned from the 1980s' savings and loan disaster was that things were made worse when no one could grasp the full magnitude of the problems early on.
Historical cost accounting isn't exactly an effective early warning system when things start going south. It's even worse when managers actually believe and act as though the financial statement fiction is the truth. In a nutshell, we wind up with good money thrown after bad. And then, of course, there is the surprise. Those who deny reality are the most astounded when it is ultimately revealed.
Reporting values accurately, early and often is a solution to what ails our economy, and not the cause of our current woes.
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.
