The Spirit of Accounting: Comparability: Defined and Redefined
We're bringing back this column from May 2008 because it makes points that many still misunderstand. Specifically, assertions that one set of global standards would bring greater "comparability" echoed through speeches and press announcements on this topic coming from the Securities and Exchange Commission, the Financial Accounting Standards Board, the American Institute of CPAs, the big firms, and others, but especially the International Accounting Standards Board.
This claim more or less originated in 2002, when the IASB started working alongside FASB and became more insistent when the former decided it was ready to take over the latter's role in the United States. The faulty premise behind this claim is that merely getting everybody to apply the same standards would be sufficient to allow valid comparisons to be made by users everywhere in the world.
Ironically, this overly simplistic idea thrived despite a joint declaration by FASB and the IASB in Concepts Statement No. 8 (issued in 2010, two years after our original column appeared) that achieving comparability is a much more complex objective, as shown in these quotes:
"Comparability is the qualitative characteristic that enables users to identify and understand similarities in, and differences among, items."
"Consistency, although related to comparability, is not the same. Consistency refers to the use of the same methods for the same items, either from period to period within a reporting entity or in a single period across entities. Comparability is the goal; consistency helps to achieve that goal."
"Comparability is not uniformity. For information to be comparable, like things must look alike and different things must look different. Comparability of financial information is not enhanced by making unlike things look alike any more than it is enhanced by making like things look different."
The boards then explain that comparability exists only when reported information is both relevant and representationally faithful.
What we see is that uniformity is a quality of inputs to the reporting process, while comparability is a quality of its outputs. Read on...
We're not sure whether we're having an epiphany or merely looking at the world a little bit differently, but we'd like to share some thoughts on comparability as a desired quality for financial reporting information. As we have described in other columns that challenged the wisdom of merging all standard-setting authority in one body, most have assumed that useful information helps users compare competing investment opportunities.
Traditionally, it's also been assumed that the investor's dilemma is deciding whether to invest in one company or another. Although this idea has significantly shaped accounting thought for decades, we believe that it's time to replace it with another.
FASB's original conceptual framework includes comparability as a qualitative characteristic of useful information, and defines it as "the quality of information that enables users to identify similarities in and differences between two sets of economic phenomena." Concepts Statement 2 ascribes political significance to the quest for comparability when it laments that there has been "difficulty in making financial comparisons among enterprises because of the use of different accounting methods," and goes on to observe that diversity in practice is "the principal reason for the development of accounting standards."
This connection to standard-setting is important because history shows that the quest for comparability has been twisted to become mere satisfaction with uniformity, which is something quite different. Uniformity is the condition in which everyone applies the same accounting rules to the same transactions and events. Uniformity brings about comparability if and only if a uniformly applied rule actually produces useful information.
For example, most everyone uses straight-line depreciation for their tangible assets. For another, most everyone accounts for non-controlling investments in subsidiaries using the equity method. For still another, everyone measures stock option expense by spreading the options' grant date value over the vesting period. And yet another example is the tortured set of procedures mandated by FASB for defined-benefit pension and other post-employment benefit plans.
The fact is, however, that uniformly applying these methods doesn't provide the relevant and reliable information that users need for predicting future cash flows. As a result, usefulness and comparability do not follow when everybody uses them.
So, what explains GAAP's long-standing emphasis on uniformity? We suggest it appeals to unwise managers and auditors because it seems to them that it's advantageous to prepare and audit information the same way as everyone else, rather than implementing more useful reporting practices that reveal more about future cash flow prospects. Because managers and auditors have long had great political influence over the standard-setting process, it doesn't surprise us that the rules reflect their narrowly conceived self-interests.
Accountants have assumed that users ask, "Should we invest in Company A or Company B?" -- but we think they ought to embrace the different idea that investors actually ask, or ought to ask, "Should we invest in Company A or not?"
That is, they consider possible investments one at a time, not in pairs. If so, they're not looking at only two companies' financial statements and converting their reported measures to the same basis, such as getting them both on FIFO or LIFO, so they can compare them against each other. Instead, they're actually comparing, for example, the market value of the target company's stock with their estimate of its intrinsic value.
Intrinsic value is an economic concept that asserts that securities (and all other assets and liabilities) have a true value based on their future cash flow potential. Its amount is elusive and otherwise hard to assess because it's ephemeral and always changing.
Nonetheless, modern investors search for any apparent imbalance between a security's current intrinsic and market values. It doesn't matter which way the imbalance tilts -- they can take a long or short position and make a profit sooner or later when the consensus market value eventually converges toward the intrinsic value.
Because securities' market values can be observed, the investors' task is to assess intrinsic value, and finding that amount involves, in part, fundamental financial analysis. If investors can complete their analyses and act in a way that helps them quickly seize opportunities from the two values' divergence, market efficiency is boosted and society is better off.
Here's our conclusion: Modern financial analysis demands reports that enhance investors' searches for intrinsic values.
This thought reveals that traditional reporting standards have been oriented on the wrong compass. Instead of trying to compel everyone to adopt the same (but often useless) practices, policy makers should support investors by granting managers more latitude to produce genuinely useful statements that transparently describe their economic circumstances so users can make better assessments of their securities' intrinsic values.
Before anyone goes ballistic, we're not advocating anarchy in which anything goes. We're confident that our regular readers know we have more aversion than most anyone else toward false information in financial reports. Liars and cheats should be both shunned and prosecuted.
What we want to do is liberate honest managers from their GAAP-based shackles that force them to lie in their financial statements by, for example, reporting depreciation expense when their assets are appreciating or R&D expense even though their labs are discovering good ideas that are worth more than they cost.
THE FAIR VALUE OPTION
In 2007, FASB issued SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities, which allows management to account for some or all of its financial assets and liabilities at their fair values. Importantly, this method flows holding gains and losses straight to income statements, whether realized or not.
This is serious accounting, and we think it ought to be applied to all assets and liabilities. Why? Simply because doing so would provide more useful information for comparing the targeted securities' intrinsic and market values. It does so by reducing users' reliance on their own relatively uninformed estimated fair values of the company's assets and liabilities. It also reduces their need to move unrealized gains and losses into reported income out of the equity section where they're dysfunctionally parked while waiting for irrelevant cash transactions. In addition, it does away with one-sided impairment accounting. Those now deeply engrained but freakishly cautious practices may make auditors feel safe and not hold managers fully accountable for volatility, but they undoubtedly produce income statements that are much less than fully useful.
In summary, value-based accounting contributes to genuine comparability because it tells the truth, the whole truth, and nothing but the truth.
WILL ANYONE DO IT?
We're hoping some chief executive and chief financial officers get the point that voluntarily adopting fair value accounting is a great way to improve the quality of their financial reports. Of course, doing so will give them advantages over other less-enlightened managers who won't do it because they're afraid to trust the capital markets to handle the truth.
Further, these innovative managers can report some values without violating GAAP because of SFAS 159, which is exactly the kind of standard that FASB needs to issue over and over again. By making innovation voluntary, the board encourages progress without compromise or compulsion. We hope this experiment is a success and that it's followed by many more.
Alas, we've checked with people who should know, and they can't say that the value option has been widely adopted. We suspect decisions to not adopt have been made by the same managers who complain that the capital markets are undervaluing their stock. Perhaps it will occur to them, or their successors, that any fault for undervaluation is completely their own for not reporting sufficiently useful information.
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 or Accounting Today. Reach them at email@example.com.