The Spirit of Accounting: Why are we so critical of the financial accounting status quo?
Over nearly 22 years, we have consistently criticized financial accounting’s status quo and its practitioners, including regulators, auditors and educators. To our disappointment, GAAP and its adherents remain fundamentally unchanged.
We see several possible reasons for this perverse resistance. One, of course, is that we’re just wrong because the status quo is essentially perfect. Although many embrace that explanation, GAAP’s numerous obvious weaknesses force us to reject it. We suspect that practitioners are oblivious to GAAP’s shortcomings because no one ever taught them how to recognize or even look for them. Shame on accounting instructors for this disconnect from reality.
We’re also certain that most new accountants’ inherent curiosity about what could or should be done differently is squelched by impatient supervisors working with budgets that don’t allot any time for theoretical discussions. Alas, these rookies quickly learn that asking questions hurts their chances for advancement.
This column probes a more significant flaw that runs much deeper than these, right down to the field’s very core.
Although the word “paradigm” may have been overused to the point that it’s become a buzzword, we’ll use it to describe a general “world view” that shapes thoughts and actions. Importantly, a paradigm often limits its adherents’ ability to perceive reality. Thus, deeply imbedded paradigms can be deucedly difficult to overturn, and progress grinds to a halt when all challenges are suppressed.
This truth persuades us that the decades-long persistence of inferior GAAP financial statements indicates that the field of financial accounting desperately needs a massive paradigm shift.
History tells us that one such shift occurred in the 16th century when the so-called Copernican Revolution led astronomers to accept the idea that the planets circle the sun instead of Earth. Actually, though, it should be labeled the “Aristarchian Revolution” because that paradigm was first described by Aristarchus, a Greek astronomer from the third century BCE! More than 1,800 years later, a fundamental change in thinking was compelled by astronomical observations that contradicted the geocentric status quo. (Ironically, Arthur Koestler’s 1958 book, “The Sleepwalkers,” reveals that Copernicus was so uncertain about his own paradigm’s authenticity that he didn’t consent to publishing his speculative treatise until he was literally dying.)
Why paradigms change
So, what’s with this non-accounting history?
Simply put, we want to nudge practitioners to acknowledge that their resistance to proposed reforms is driven primarily by their engrained inability to question their longstanding paradigm. In effect, their reluctance is so strong because their world view conceals accounting’s multiple glaring flaws from them.
Nonetheless, we hope for a breakthrough because many recent disruptive paradigm shifts have occurred with astonishing speed. Perhaps the most amazing is the rapid evolution from wired telephones, first to mobile phones and now to smartphones that are really handheld computers we can also use to make calls.
So, why do some paradigms change quickly? Our best answer is that the pace depends on how much the shift can change daily lives. In the solar system case, people managed to get by without knowing which body orbited the other because they weren’t directly affected by that issue. Basically, the sun-centered paradigm wasn’t adopted quickly because virtually nobody cared. In contrast, billions of people swiftly embraced the smartphone paradigm because these devices positively impacted their lives.
Back to accounting
So, how do these points relate to financial accounting? We suggest that practitioners are persistently reluctant to initiate reform because their subliminal commitment to the current paradigm renders them unable to conceive of, much less embrace, a different one. Because most accountants are as uncritical of their paradigm as people used to be about geocentricity, they are profoundly unable to perceive any incentives for shifting. Instead, they dismiss all innovative changes as “ivory tower nonsense.”
Further, rejecting reforms also maintains whatever control they have over standard-setting, other regulation, and education. In short, questioning the paradigm would stoke a fear of losing their power.
We’re convinced that the consequence of practitioners’ inability to change is a status quo that is an unserviceable hodge-podge remnant of out-of-date practices. Specifically, we find today’s GAAP financial statements are as far removed from reports that meet the capital markets’ needs as hand-cranked telephones differ from smartphones. It follows, then, that financial accounting is stunningly ready for disruption.
Toward that end, we’re offering up paradigm-challenging truths to suggest that today’s financial accounting is bound to collapse. So, why would it?
It’s because the inability of practitioners to question their paradigm also keeps them from actually serving accounting’s ostensible information-providing purpose. Although they say they aim to present useful information, many inconsistencies between those words and their actions prove otherwise. Ultimately, their choices always favor what’s useful to themselves, not users.
Useful or used?
We predict that practitioners will defend GAAP statements by claiming that surely they must be useful. After all, don’t most financial analysts use them?
In response, we note that a crucial significant difference exists between being used and being useful. An observation that something is used doesn’t necessarily mean it’s actually useful, especially when no other options are available. For example, people can remove bottle caps with their teeth when nothing else is on hand, but an opener is surely better for retaining tooth enamel.
So it is with GAAP statements: The fact that analysts diligently scrutinize financial reports indicates only that they’re used, not that they’re fully useful. Instead, we suggest analysts peruse them only because little or nothing else is available.
Therefore, we’re pleading for a paradigm shift that will redirect attention away from, for example, past facts and suppliers’ preparation issues toward useful current facts and users’ interpretation issues.
We’ll present our case by contrasting what we call today’s status quo “financial accounting” paradigm and the alternative “financial reporting” paradigm that will lead to actually providing useful information. We turn now to the first difference listed in the nearby exhibit (see “Pick your paradigm,” below), and we’ll deal with others in future columns.
We start our consideration of the competing paradigms’ focus with this humorous Monday morning office conversation:
“Hey, how’d your weekend go?”
“Great! I spent most of Saturday teaching my dog Ruby how to speak English.”
“That’s fantastic! What words can she say?”
“But I thought you said you taught her to speak English?”
“Oh, I taught her but she didn’t learn anything.”
Our point is that a process and its outcome are two very different things.
Specifically we believe the accepted financial accounting paradigm is characterized by practitioners’ misdirected focus on processes for developing numbers that show up in financial statements. For example, consider defined-benefit pension accounting where accountants perform all sorts of arcane machinations to produce a number called the year’s cost. After that process passes an audit for compliance with the applicable standards, the computed amount flows into the statements with no additional questions asked.
In contrast, the financial reporting paradigm would lead practitioners to confront the far more important question of whether the calculated amount would convey genuinely useful information when it’s reported. If that test is failed, it doesn’t matter one iota whether or not the accountants faithfully executed the compilation process.
Among many other examples of standardized GAAP processes that produce non-useful outcomes are those involving LIFO, depreciation, amortization, impairments, leases (despite the new standard), deferred taxes, interest allocations, stock options, earnings per share and the cash flow statement.
Although standard-setters claim (and may believe) that they have pursued the aim of producing useful information, political considerations have virtually always thwarted that goal. Instead, standards mandate only those processes that managers are willing to implement and auditors are willing to audit. The negative result is financial reports that don’t come close to serving users’ needs.
The bigger picture is that the status quo remains largely unchanged after eight decades of setting standards because adherents to the existing paradigm cannot see their shortcomings and thus cannot challenge them.
Happy hour blues
Let’s eavesdrop on this Friday happy hour conversation that starts with a question from an accountant’s friend:
“Hey, how’d your work week go?
“Great! I spent five days figuring out depreciation expense and the book values of all my company’s fixed assets.”
“That’s fantastic! How much are they worth?”
“I don’t know.”
“But I thought you said you figured out their values?”
“Oh, I did, but not their real values.”
And so it goes. Financial accountants are so obsessed with their processes that they never assess whether the outcomes are actually useful.
A costly status quo
We assert that a shift to a radical new paradigm is needed because the old one is too costly. We justify that claim with this irrefutable logic:
- Leaving users uninformed creates uncertainty for them;
- That uncertainty increases their perceived risk;
- Their elevated risk compels them to demand a higher return from their investments (debt or equity);
- That higher return for them equals a higher cost of capital for borrowers and stock issuers; and,
- The ultimate outcome is inefficiently low security values.
Therefore, the status quo paradigm wreaks havoc for literally everybody because it gives rise to inefficient capital markets and excessive capital costs. If so, why cling to it even a moment longer?
We openly declare that we want to rock the profession and the capital markets just like the Copernican model forced astronomers to rethink everything they believed.
This paradigm shift is way overdue.