When the hot-air balloon lifted off, the dawn weather was impeccable. Shortly thereafter, a terrible storm hit and engulfed the airship in thick clouds, heavy rain and unpredictable winds. After hours of bad weather, the pilot was relieved to once again see the ground, but the landscape was unrecognizable. Soon, however, he spotted a strolling figure and cried out, “Where am I?” The person on the ground shouted: “You’re in the basket of a hot air balloon!” The pilot cried out: “You must be a CPA!” The surprised stranger answered: “How did you know?” The pilot smiled and shouted, “Because you gave me very accurate but totally useless information.”The CPA on the ground in this after-dinner-speech ice-breaker reminds us of those in our profession, probably a majority, who still cling to the status quo in spite of plentiful evidence and common sense that it no longer serves the purpose that it once might have, many decades ago.
TWO SHORTCOMINGS
We find two shortcomings in those who staunchly defend existing generally accepted accounting principles and audit practices. Specifically, they:
* Overlook the flaws in the familiar, and;
* Disregard the advantages in the unfamiliar.
This combination is unfortunate because adherents of the status quo can only trudge along, passing out accurate but useless information while financial statement users are starving for more facts about companies’ present economic situations so that they can predict future cash and wealth flows.
By failing to stop and assess the usefulness of what they’re doing under the artificial shelter of compelled compliance with GAAP, they are blinded to their inadequacies and are still swallowing inane arguments against progress, most specifically financial reporting based on current fair values.
PRO STATUS QUO
The May 2008 issue of The Journal of Accountancy included a brief commentary by Paul Miller, “The capital markets will be served,” in which he showed how the sub-prime crisis was caused by bad risk-taking activities, not by mark-to-market accounting. He also made the case that capital markets are not bound to use the contents of public financial statements if they aren’t useful. (It was republished in the June 2-15, 2008, issue of Accounting Today.)
Among the e-mails responding to Paul’s thoughts was one from a CPA and company controller (for convenience, we’ll call him Tom). With great, even admirable, fervor, he defended the status quo against the ravages of value-based accounting practices. In making his case, he provides arguments that suffer from the short sightedness cited above. We aren’t writing to discredit Tom or cast aspersions on his fervor or integrity. Rather, we see his e-mail as a bellwether that indicates that many intelligent accountants are trapped in an old paradigm that needs to be replaced by a different view of the financial reporting world. To help others see what’s wrong with these views, we are analyzing some of his points in this column and the next.
AUDITS’ CONTRIBUTION
One of Tom’s premises is that audits are important; he then concludes that market values are bad because they’re subjective. Here is his first point: “No matter one’s position on fair market valuation, one assuredly agrees that an audit adds value to financial reporting, that an annual report absent an opinion letter is of dubious value.”
He’s right, of course. But what he misses is that an annual report with an opinion is also of dubious value! Specifically, it does no good to audit a report that fails to provide useful information. An audit cannot make GAAP statements useful any more than an alchemist can turn lead into gold or a weaver can turn a sow’s ear into a silk purse.
What we see in his premise is a reflection of the profession’s blind spot that causes it to overlook the fact that, more often than not, compliance with GAAP doesn’t produce useful information.
‘DANGEROUS’ SUBJECTIVITY
Tom’s second main point is a classic defense of objectivity. He says, “When we increase subjectivity, we decrease value [of the financial statements].” Contrary to his assumption, objectivity and historical costs do not go hand in hand.
In particular, he is so accustomed to the subjectivity inherent in GAAP measures and practices that he doesn’t see how they presently drag down usefulness. What, pray tell, are future service lives, salvage values and depreciation patterns except predictions that cannot be verified because the truth won’t be known until the future unfolds? What about bad debt losses (lots of those have occurred lately) and the expected return on pension assets?
Nothing but subjective numbers.
Tom makes another big mistake when he assumes that fair value information is automatically subjective. In fact, basic value information is often far more objective than historical costs. As we explained in our first “Mythbuster” column (June 16-July 7, 2008) an asset’s original cost is based on only one data point from one past transaction, while value measures are based on multiple transactions from recent transactions. Of course, some values are tough to develop because of uniqueness, but then an awful lot of costs are also wild-eyed guesses.
ONE MORE POINT THAT
Tom misses is that GAAP accounting is already laced with market-based measures. Perhaps the most overlooked are the amounts assigned to assets and liabilities involved in business acquisitions. Other applications include impairment situations where fair values are lower than book values. We used to wonder why status quo huggers like Tom don’t argue for abandoning asset write-downs because value measures are too subjective. The next section explains why they embrace values in those cases but not when they’re greater than book value.
AUDIT RISK
Tom boldly proclaims, “The application of fair market valuation increases audit risk, thereby decreasing the value of the audited financial statements.” We think this unsupported assertion contains two mistakes. First, it mentions only the risk faced by auditors. That risk doesn’t impact financial statement utility; it just makes auditors more uncomfortable and more expensive.
Second, it completely ignores the other relevant risk, specifically the one faced by statement users when they don’t know the whole truth about what has happened or what the company owns and owes. This information risk drives capital costs through the roof, but status quo adherents act like they don’t even know it exists.
Despite the standard rationale that impairment accounting protects users against surprise losses, it doesn’t protect them against surprise gains. All it does is protect auditors against their risk of retribution while leaving users with only half the information they need.
To emphasize our point, if fair values are acceptably objective when they’re less than book value, they are equally objective when they’re greater than book value. After all, book value is merely an arbitrary amount in the accounts; it cannot possibly exert any influence on the subjectivity or objectivity of fair value estimates, any more than the location of Jupiter among the constellations can determine whether you’ll have a good day tomorrow.
INTERMISSION
At this point, we hit the pause button and invite readers to come back in the next issue to read our comments on the rest of Tom’s e-mail. When we do, we’ll talk about a list of behaviors that he mistakenly claims have maintained the accounting profession’s integrity. We’ll also point out his failure to recall the Enron era, including the vaporization of an entire international CPA firm.
Finally, we’ll hold up to scrutiny the contradiction between his correct observation that fair values are useful for financial analysts and his puzzling conclusion that accountants should not provide these key users with any information about those values.
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.
