by Paul B.W. Miller and Paul R. Bahnson
Over a span of what is now quite a few years, the two of us have been privileged to be academic accountants. Part of the job description requires us to think a lot about ideas that practitioners don’t have the time or inclination to ponder.
In addition, we have been sheltered by the fundamental purpose of tenure — the protection of our academic freedom to pursue controversial and unpopular ideas without fear (unless, of course, our actions are unethical).
Furthermore, we both have had the privilege of being on the staff at the Financial Accounting Standards Board in the 1980s, a pivotal time for both the board and financial accounting practice. Paul Miller worked on the Conceptual Framework project in the recognition and measurement phase, and Paul Bahnson was a key member of the project that evaluated the results of implementing SFAS 33, which required larger companies to disclose information about their assets’ market values.
When these pieces of our background are brought together, it only makes sense that much of our above-and-beyond thinking has occurred in the area of value-based financial statements. We have written more than a little about it, too, with our most complete analysis of the issues appearing in “Quality Financial Reporting” (McGraw-Hill, 2002).
Our immersion in the issues has convinced us that great benefits will flow from introducing more values into financial reporting. With some chagrin, we recently discovered that others don’t see this situation as clearly as we do.
Given the gulf between our views and theirs, we have decided to devote the next several columns to explaining why the increased use of market values in financial reporting would be a good thing. We know from experience that even raising the issue will cause brimstone and brickbats to be tossed our way; however, we are committed to increasing the quality and usefulness of financial reports well beyond their present pitiable state — a fact that is surely recognized by all but the most staunch supporters of the status quo.
The gulf of disagreement is so wide that it requires a change in paradigm to even see the need for reform, much less move toward progress. Because we have crossed over this paradigm gap ourselves, we understand how difficult the leap to a new mindset can be. Our efforts, to date, have also taught us how challenging it can be to get people to make the leap for themselves. But, hey, we’ve got tenure and we’ll take the time and make the effort to put our thoughts out as a challenge to others.
To get started, we emphasize that we are persuaded that the FASB members of the 1970s and early 1980s got some things absolutely right in the first parts of the Conceptual Framework.
We believe, for example, that they showed great wisdom in Statement of Financial Accounting Concepts No. 1, when they identified the main objective of financial reporting as providing investors and creditors with information that is useful for making investment and credit decisions. (Even though no one would come out and claim that information in the financial statements should be useless, many people make that argument implicitly by supporting various practices like omitting options expenses and others facilitating off-balance-sheet financing.)
FASB did not stop with that objective, but went on to explain what it meant at three levels. First, it explained that investors and creditors are concerned about cash flows to themselves in the form of interest, dividends, proceeds from sale and collection of principal. Second, it explained that, in anticipating those cash flows, investors and creditors will find it useful to assess the amount, timing and uncertainty of future cash flows to the entity. (Because this idea is especially important for understanding the promise behind value-based financial reporting, we will come back to it often in this series of columns.)
The third level of explanation simply states that investors and creditors will find it useful for assessing the entity’s cash flows if they have information about its resources, obligations and changes in them, eventually identified in SFAC 3 as assets, liabilities and comprehensive income.
In SFAC 2, the board members made another huge step forward by unanimously agreeing that information is useful only when it is both relevant and reliable. Information that is merely reliable but not relevant to decisions can never be useful. Similarly, relevant information is not useful if it lacks reliability.
Although these qualities seem parallel, they are quite different. In particular, additional effort expended to enhance the reliability of relevant but unreliable information will make it more useful. However, no amount of effort or expense, no matter how great, can ever add usefulness to irrelevant information. Again, this point forms a key basis for our view on the advantages of moving toward value-based accounting.
Further, the board members made yet another incredible leap in SFAC 1 into new territory that has apparently not yet unseated the dominant paradigm. We’ll explain it carefully, because it, too, is a foundation for a revolution.
Here is the leap: The qualities of relevance and reliability must be defined as they are perceived by the users of the financial statements. The users are, in effect, the consumers of information. They are the ones who demand the information.
Further, they are willing to pay a price to obtain that information, in the sense that they bid up the value of securities when they have more confidence that they know what they need to know about the entity’s future cash flows.
To repeat: It is users’ needs that must be addressed if financial statement information is to be useful and, thus, worth reporting. It simply does not matter what managers are willing or unwilling to report, or what auditors are willing or unwilling to audit. To be plain-spoken, the statements are worthless if they do not contain information that users need.
Here, then, is the big bang of the paradigm shift — users (not auditors or preparers) are at the center of the financial reporting universe, and the policy-making process should be directed first at discovering the nature of those needs and then at developing techniques for serving them.
Yet it appears to us, and a growing number of others, that the standard-setting and financial reporting systems have long had the cart before the horse. Because accountants set standards and managers greatly influence the political process, the result has been practices that satisfy managers’ and auditors’ needs, while leaving users high, dry and unfulfilled.
Thus, as our conclusion of this first installment, we find great support for moving to value-based accounting in the prospect that it will, at long last, address users’ needs for relevant and reliable information that helps them make useful assessments of the amount, timing and uncertainty of future cash flows to the entity.
There is more — much more —to be said. Stay tuned.
