It’s our busy season, and we’ve revised our column from December 2014 that delivers a coup de grace to the notion that the status quo is and always will be good enough. Our message is even more crucial because of the obvious lack of evidence that anyone in accounting wants to significantly innovate. We urge you to take it to heart.
The October 2014 issue of Accounting Today included editor Daniel Hood’s gleanings from comments by various leaders in the accounting profession on key issues in the 21st century. The following thoughts on “relevance” raise the crucial issue of whether accountants are positioned to provide services that will actually be demanded (italics added):
- Rick Telberg said, “The profession as a whole, across the globe, in public practice and in industry, teeters on the brink of competitive irrelevancy and irreversible obsolescence.”
- Sharada Bhansali raised an alarm by saying, “The profession is losing its relevance and many accountants have settled for this compromising situation.”
- Tommye Barie proclaimed that, “CPAs risk losing relevance in the marketplace without ensuring our services provide value in a timely and meaningful manner.”
- Ron Baker asserted, “Unless our profession continuously innovates and adds value, we deserve irrelevancy” and added this challenging question: “What was the last innovation from the profession?”
We absorbed these thoughts in light of ideas described by Peter Thiel and Blake Masters in their book Zero to One, which explains and encourages radical innovation. In our eyes, the fact that none of the profession’s attempts to innovate has ever been revolutionary proves it has already become irrelevant.
Zero to one?
A co-founder of PayPal and one of the most important futurists in the U.S., Thiel assesses whether job-seekers have the potential to work passionately at innovating by asking them, “What important truth do very few people agree with you on?” When he says “very few people,” he means a really small number because he knows significant innovation is unlikely without a unique perspective on truth different from the status quo.
His own view is, well, innovative because it involves two kinds of progress. He calls one of them “horizontal,” by which he means building new things that merely improve on previously existing things, such as electric typewriters replacing manuals, and spinning type balls superseding type bars. He characterizes this progress as “one to n.”
Another example is globalization, which Thiel says has tried to replicate what worked in the U.S. in the 19th and 20th centuries. He observes that it’s just not possible to re-create American lifestyles in countries with, for example, less real estate and more people crammed into small spaces. In contrast, he uses the terms “vertical” and “zero to one” to describe innovations that have the greatest potential for progress because they are more likely to create disruptive revolution instead of slow and steady evolution. For example, word processing didn’t just improve on typewriters but essentially eliminated any need for them. Indeed, it has changed the whole written communication process.
Notably, Thiel doesn’t perceive innovation and progress as automatic. Those who strive to achieve them must be courageous and willing to work hard and take risks while facing opposition and ridicule.
What, then, do these ideas mean for accounting? We find that they clearly support our long-held position that financial reporting has been largely stagnant for close to a century. Basically, we fear accountants have plodded along horizontally for decade after decade without ever trying to significantly improve financial reporting’s impact on capital markets, economies, and eventually society itself. Sure, they’ve embraced new data processing technologies, but have applied them only to doing the same inferior things they’ve always done.
For examples, consider cost-based depreciation, financial statement structures and reporting frequency. Technology’s primary contribution has been helping accountants compile and publish their outmoded messages more quickly with less physical effort. Even though the statements are cheaper to prepare and distribute, their content is stuck in a 20th century time warp. Here are five examples:
- Spreadsheets and other software calculate cost-based depreciation amounts more efficiently with greater arithmetic precision without doing anything to produce actually useful information about the assets’ values. Instead of describing real observations of real facts, accountants keep reporting meaningless numbers based on biased assumptions and unverifiable predictions.
- Balance sheets still classify account balances as current and noncurrent with criteria that originated no later than the mid-1930s. Without a doubt, users need more useful details to help them anticipate future cash flows.
- Despite users’ expressed desires for cash flow statements that use the direct format, managers keep presenting the indirect format that was begrudgingly retained back in 1987 by the politically beleaguered Financial Accounting Standards Board. After all, it had been cobbled together by ingenious analysts in the 1930s to cope with the statement’s unavailability.
- Today’s highly sophisticated computer systems are used to prepare public financial statements once every three months, exactly the same frequency that came into common practice in the 1930s when so-called “electronic brains” were only outrageous dreams of science fiction writers.
- Despite FASB’s taxonomy and Securities and Exchange Commision-mandated XBRL presentations, neither achieves their full potential because they’re applied to outdated and otherwise irrelevant data produced under “pitifully old and obsolete principles” (POOP).
The right question
We like Thiel’s thinking because it meshes with our idea that the best way to achieve vertical innovation and zero-to-one progress involves completely changing practitioners’ ingrained paradigm for financial reporting.
In particular, the dominant thinking that has always shaped practice is satisfying the needs of managers, their accountants and auditors. The three crucial questions about financial reports under this old paradigm are:
- “How good (or bad) will they make management look?”
- “How much will it cost to prepare them?”
- “What risk will they create for auditors?”
In contrast, we are clearly alone in comprehending that financial reporting should instead be shaped by answers to this single straightforward question: “What information do report users need?” Pursuing those answers will change most everything accountants do for the better. Specifically, meeting users’ needs would drastically reduce their conflicts with preparers. Right now, the latter are always trying to coax the former into believing what isn’t completely true by reporting as little as possible, spinning things to look better, and obscuring any bad news. What these managers ignore is the fact that users always wonder what, if anything, they can safely believe and act on. This uncertainty compels them to speculate about not only what management has concealed but why.
This inefficient communication relationship raises users’ suspicion and distrust, which boosts their uncertainty and risk, and inevitably increases companies’ capital costs.
We believe this unproductive status quo is rooted in managers’ naive yet persistent misperception that financial reporting is a zero-sum game that they would somehow lose if they were to fully inform the markets about all their news, both good and bad.
In fact, their failing to report the truth, the whole truth, and nothing but the truth always promotes doubts and skepticism. The lack of useful data compels users to search for other non-primary and less credible information to uncover what’s wrong with the published statements. In effect, management’s deliberately created data deficits force users to increase their demanded return to compensate for their wasted time and effort.
When the dust settles, everybody loses from this pointless game.
On the other hand, if managers were to publish the complete truth more frequently and clearly, then users would consume their reports with more confidence without having to seek as much supplemental information from second-hand sources.
The ultimate outcome would be investors and creditors who would be satisfied with lower returns that would in turn decrease a company’s capital costs and increase its securities’ values. Market efficiency would also improve.
In addition, managers would find it less stressful to stop massaging their messages and just report the truth. As a bonus, they would also discover that truthful information helps them run their companies more productively. In short, everybody gains.
Yeah, but …
Of course, some managers would complain about the high cost of reporting more information. In response, we ask them whether they have ever actually attempted to measure their present high combined preparation and capital costs of reporting useless information in GAAP financial statements. We’re convinced they’d be horrified to discover how wasteful their reporting process really is.
Two steps and a big idea
As first steps, we propose these two innovations:
- Reporting more frequently than quarterly.
- Basing financial statements on observed current market values instead of allocated and assumed book values derived from irrelevant original costs.
Another new idea would be a universal recognition by everyone, including FASB, that financial reporting standards can establish only minimum requirements. Ironically, virtually everyone treats them as defining the maximum they have to do. However, astute preparers who realize that users want more information will realize they can voluntarily exceed the minimums and emerge victorious over their capital market competitors.
This big idea would not only change how preparers approach reporting but also awaken standard-setters and other regulators of their social obligation to improve their service to the capital markets and the economy.
This radical zero-to-one innovation toward serving users’ needs would begin to change everything for the better. However, without it, today’s irrelevant financial reports and audit opinions (and those who publish them) will deservedly become bizarre oddities in the future, exactly as forecast by the leaders in this column’s introduction.