by Paul B.W. Miller and Paul R. Bahnson
This is our second column in a series on making the paradigm leap from the way things are in financial reporting to the way they can be. One pivotal issue that holds many back from making the leap is the question of whether market values are useful.
In the previous issue, we explained that the Financial Accounting Standards Board’s Conceptual Framework appropriately identified financial reporting’s objective as providing useful information to investors and creditors for decisions that involve assessing the amount, timing and uncertainty of the reporting entity’s future cash flows.
FASB set a course for change by insisting that useful information must have both relevance and reliability. Neither is enough on its own, but taken together, they create usefulness. We also explained that relevant but unreliable information can be made useful by improving its reliability. In contrast, irrelevant information, however reliable, can never be made useful.
Furthermore, users’ needs must be served in deciding what’s useful, including how much reliability can be attributed to measurements. Of course, preparers and auditors must be involved in the reporting process; but, by analogy, they are like chefs and waiters in a restaurant — their purpose is to prepare and serve what customers want to eat, not what they themselves want to prepare and serve.
Thus, preparers will prosper only if they satisfy investors and creditors, just as auditors will prosper only if they actually make relevant information more reliable for users.
We now turn to asking what sort of information about assets and liabilities is relevant to users. As we see it, information is relevant if it informs users about the ability of an asset or liability to affect the reporting entity’s net cash flows.
Reflecting the common sense in FASB’s framework, information is relevant (and useful) only if it has timeliness. Information is timely if and only if it provides up-to-date contemporary insights into the amount, timing and uncertainty of future cash flows as of the reporting date. Traditionally, accountants have acted as if timeliness is achieved by publishing reports on or before legal deadlines. That is, they see that information is timely if it is released on time.
As we look at timeliness, we see that it exists only when the information content included in on-time reports actually reflects relevant facts as they are known on the release date. It does no good to report amounts that are no longer timely.
For example, an investment in 10,000 Enron shares used to be worth close to $1 million dollars, but it’s now pocket change. An investment in 10 shares of Berkshire Hathaway used to be pocket change, but it’s now worth almost $1 million dollars. The earlier amounts are reliable descriptions of the cash flow potential at the past dates, but they are no longer timely, regardless of how promptly the balance sheet is presented.
All these points about users’ needs, cash flow potential, and timeliness provide compelling evidence for the need to explore the use of recent values to describe assets and liabilities and to measure income based on changes in those values.
To explain the relationship between cash flow potential and market value, we observe that if two assets have the potential to produce future cash flows, the one that currently promises to produce more cash will have a higher current market value, all other things being equal.
If two assets have the current potential to produce the same cash flows but with different timing, the one that currently promises to produce cash more quickly will have a higher current market value. And if two assets have the potential to produce the same cash flows at the same time but not with the same degree of certainty, the one that is more certain will have a higher current market value.
When viewed from this perspective, it is clear that market values reflect the amount, timing and uncertainty of future cash flows. Therefore, information about current market values tells users what they need to know. This current information is far superior to facts about old costs (or residuals of those amounts) simply because they don’t reflect the existing cash flow potential.
So, if current market values are relevant for decisions made by users, we must ask whether they are reliable. That is, are they neutral, verifiable and faithful representations of the cash flow potential of the assets and liabilities? The answer lies in understanding market value.
As we see them, market values represent consensus valuations for assets or liabilities that reflect the amount, timing and uncertainty of the future cash flows related to them. This consensus exists among multiple participants, including buyers and sellers separate and distinct from the reporting entity. As a result, they are neutral.
Can market values be verified? Of course they can, to varying degrees and at varying cost. All that is needed is access to information about a large number of recent transactions that don’t involve the reporting entity. Are market values faithful representations of cash flow potential? Again, the answer is: “Of course,” as long as the market is sufficiently deep to produce multiple independent transactions.
At one end of the spectrum are marketable securities, where there is ready, even free, access to continuously updated information about recent exchange prices. At the other end are intangible assets that are so scarce that they cannot be involved in multiple transactions. The ease of verifying the former does not justify blithely reporting contrived fictitious values for the latter. Inversely, the difficulty of measuring the intangibles’ value doesn’t justify withholding the values of investments, or of any other assets or liabilities that can be measured reliably.
As an analogy, a restaurant shouldn’t refuse to serve burgers because the cook can’t do a Beef Wellington. Why would limitations in one reporting area preclude pushing toward excellence in others?
An age-old argument against value-based reporting needs to be put to rest. Many accountants defend the status quo by claiming that actual costs are reliable while hypothetical market values are not.
We see a couple of points to make. First, it doesn’t matter how reliable costs are if they are untimely descriptions of cash flow potential from the past.
Second, market values are not hypothetical. Traditionally, the accounting literature has described market value as the amount an owner would receive if it sold an asset or the amount it would pay to replace it. As framed, these values are indeed hypothetical. However, market values are amounts that many sellers are actually receiving and that many buyers are paying. They are real, not hypothetical. We also apply a little bit of statistical logic.
Specifically, we see market values as distributions of amounts paid and received in a large number of transactions. In most cases, this distribution is bell-shaped. The dispersion among the observed prices depends on the number of transactions, the time frame under observation, and the markets’ efficiency.
It is unarguable that the distribution’s mean is an expected market value that provides superior predictive information over any single point in the distribution. This mean can be determined only by access to multiple events, none of which should involve the reporting entity.
This analysis exposes the flaw of the traditional practice of reporting original cost, because that amount represents only a single point on the distribution, and a non-random point at that. When its un-timeliness is considered, historical cost is both irrelevant and unreliable. One can only imagine how any reliability could remain after applying systematic amortization processes using predictions and assumptions.
As a result of our analysis, we are quite confident that current market values provide information that depicts the ability of an asset or liability to affect the amount, timing and uncertainty of future cash flows far more reliably and usefully than any other alternative.
Is this logical conclusion enough? Perhaps, but let’s return to our restaurant analogy — commercial disaster would ensue if chefs only logically analyzed what customers wanted, and then served it without regard to what was ordered.
Another important test involves finding out what customers want. We take up this sensible point in our next column. Unfortunately for some, there is little expressed demand for historical numbers and much evidence that sophisticated users want market values.
If you don’t believe us, wait and see.
Register or login for access to this item and much more
All Accounting Today content is archived after seven days.
Community members receive:
- All recent and archived articles
- Conference offers and updates
- A full menu of enewsletter options
- Web seminars, white papers, ebooks
Already have an account? Log In
Don't have an account? Register for Free Unlimited Access