by Paul B.W. Miller and Paul R. Bahnson
Pardon us as we pause and take a look back. This column is the 150th to appear in consecutive issues of Accounting Today. The idea for The Spirit of Accounting was born in 1995 when Ed Ketz and Paul Miller had written a paper about ethics in financial reporting. After it was published, the ideas caught the attention of Rick Telberg, this newspaper’s editor at the time. He asked if we might want to put together three or four short columns based on ideas we had expressed, and we said, "Sure, why not?" The chemistry clicked between the two of us and with the readership (well, most of it, anyway). So we kept it up.
Ed stuck with it for 100 columns, and then Paul Bahnson came on board. The two of us have a long relationship dating back to when we were teamed as faculty mentor and Ph.D. student at the University of Utah. Since then, we had worked together on some papers and co-authored The FASB: the People, the Process, and the Politics, a book that captured 100 percent of the market for analysis of the oft-beleaguered standard-setter (and our former employer). We share the same ambitions for the profession and the same disappointments with the status quo, so it made sense to work together on the column.
While we could spend a lot of time in retrospection, we want this column to look to the future. As demanding as the biweekly deadline is, we are not ready to call it quits. The events of the last year or so have actually invigorated us because they affirm that we are right to be so concerned about the state of ethics and the deficiencies in GAAP. As a result, we intend to keep going until you lose interest in what we have to say.
As to the future, we see huge challenges facing the accounting profession and those whom we serve, including corporate accountants, managers, financial statement users, the capital markets, and the public in general. The sordid revelations of the last 12 months have exposed a variety of bad attitudes that we think need to be changed. Many of them come from the corporate side, but not exclusively. We are eager to do what we can to encourage change.
First, we call on management to develop a new attitude toward the recipients of financial reports. We have over and over again observed a general disdain for the users’ needs for useful information. There has also been a tendency to underrate the markets’ ability to see through the fog and smoke put up in the reports. In place of this bad attitude, we encourage managers and CFOs to look upon statement users as partners in a common enterprise, not as competitors. Instead of a zero-sum game in which managers lose if users win (and vice versa), we think the relationship can be changed into a win-win. If managers are forthcoming, users make better decisions under less uncertainty, the cost of capital drops, and stock prices rise. Everyone is better off, except for the very few who have successfully deceived the markets, and why should their loss be mourned?
Another attitude that needs reformation is the way that managers look upon GAAP. Many seem to view compliance with these politically derived rules as sufficient for informing the capital markets. A new attitude would see GAAP as only the barest of minimums. Because the standard-setting process is political, it simply cannot establish exactly what needs to be revealed to produce fully informed investors and creditors. It certainly cannot be counted on to be the source of all innovation. Instead of asking at the end of the preparation process whether the financial statements comply with GAAP, managers need to ask, (1) "Are they useful?" and, (2) "What can we do to make them more useful?"
A third flawed attitude is displayed by corporate managers and accountants toward FASB and the IASB. Virtually without exception, those who speak on behalf of the preparer constituency, primarily the Financial Executives Institute and the Business Roundtable, but also the American Institute of CPAs and the Final Four, belittle the board’s efforts and take strong stances against its new proposals. Before long, the spokespersons threaten to undercut the boards’ authority and funding.
What nonsense! The standards are created to improve financial reporting so that capital costs are reduced through decreased uncertainty. These tantrums are childlike in their shortsightedness. What’s missing is the understanding that influencing standards to allow management to look good satisfies only their egos and does nothing to produce investor confidence and higher stock prices. Just look at the long list of belly-up companies with executives who managed the financial statements without minding the store. It’s time for the corporate world to embrace standard setting as a means of improving what they do instead of treating it as an obstacle.
A fourth attitude that should be altered involves a great many more than corporate types. In fact, it goes so closely together with a fifth that we’ll talk about them together. Specifically, we’re convinced that it is time for everyone to re-evaluate their satisfaction with historical cost-based numbers and to reconsider their fear of market value-based numbers.
Our classrooms are a microcosm of the real world in the sense that we encounter there what happens outside. At the intermediate level, we find some students who are already either unwilling or unable to see the flaws in GAAP reports that keep them from being useful for any sort of decision. They learned how to do the entries and how to put together statements that balance, but they never ask whether the output provides what capital markets need for making rational decisions. Before long, we are able to get them to see that their approving attitude toward historical costs perpetuates the provision of irrelevant and unreliable numbers.
The students who cling to historical costs also maintain a visceral aversion toward market values, typically expressed as a dismissal because of their lack of reliability. This revulsion is unreasonable and even uneducated. Perhaps it is more a result of poor education. An historical cost is the outcome of only one transaction involving the interested party. Market values, on the other hand, are the product of multiple transactions involving parties other than the reporting company. There can be no doubt about the relevance of market value information, except in the most closed of minds. If unreliability is an obstacle, as it clearly can be, then it makes sense to apply technology and creativity to overcoming that limitation.
In contrast, there is nothing anyone can do to make historical cost data relevant for future decisions. Further, tremendous unreliability surrounds historical costs because they are subjected to various arbitrary allocations based on unverifiable predictions of future events and conditions. Unless these attitudes are changed, financial reporting will never live up to its objective of providing useful information to the capital markets. Perhaps more to the point, the continued refusal of accountants to change will make them irrelevant and without value.
The same narrow-mindedness surrounds the incredible focus on reported earnings. (We insist on using the word "reported" to ensure that the number in the statements is not confused with "real" earnings.) So many policy choices are available to management that any attribution of precision and comparability to reported earnings is faulty, ridiculous, and even ludicrous. Our previous column referred to the Intel chief financial officer’s rationalization of pro forma disclosure of options expense because he didn’t want the estimated cost of options to pollute the high quality of the reported earnings. First of all, he missed the point that leaving out an expense badly pollutes the earnings number. Second, he missed the equally glaring point that so many predictions enter into the GAAP earnings number that it probably lacks even one significant digit. Maybe, just maybe, reported earnings is accurate to the nearest order of magnitude, but we’re not about to grant even that result as certain. Here is our advice: Quit thinking of earnings as everything. The consequence will be more complete reporting about what happened, not just a bottom-line oversimplified and overglorified result.
Finally, with the departure of Andersen, clearly there is a need for a new attitude toward audits. The fundamental purpose of an audit is to add value by reducing uncertainty about self-representations generated by managers who cannot be trusted to be objective. If auditors are not free to pursue their investigations, no value is added. If auditors are not perceived as independent because of non-audit fees, no value is added; in fact, value might be taken away. For that matter, we insist that the very existence of audit fees rob the audit of its full value. Despite the negative impact of these forces, we have seen auditors willingly give away their independence and managers gleefully doing all they can to compromise it, just so they can report what they want to report instead of what the markets really need. What a bad attitude, all the way around. It’s more than time for a change and some new thinking.
All of these comments have come up in our past 150 columns. We venture to say that they will return time and again in the next 150. Rest assured, we have no fear of running out of topics, nor do we worry about running out of steam.