We’ve shown in previous columns that GAAP reporting is unethical because it’s not fully truthful. We’ve also identified 14 myths that help perpetuate that inexcusably disgraceful condition by keeping market values out of financial statements. Six of them have already been debunked, and another five are about to follow.
MYTH NO. 7
“Market value information is too costly to update.”
To start, nobody can rightly assert that something is “too costly” without first measuring its benefits. Yet market-value opponents smugly refuse to consider the good that would come from reporting them.
Moving on, we’ll acknowledge that this myth might have been true not so long ago. However, many kinds of facts are now literally at everyone’s fingertips because enterprising innovators are instantly delivering useful information out of massive new databases.
For example, people can access up-to-date information about such things as stock quotes, locations of en route subways and airplanes, their cars’ whereabouts, real estate and vehicle values, and weather conditions. So much data is so easily available that organic memory devices (a.k.a. “brains”) are rapidly becoming optional equipment.
In any case, these services have exploded because they’re feasible, in demand and lucrative.
With regard to financial reporting, we project that information-savvy entrepreneurs will soon build databases of market values for all kinds of assets and sell their contents to sophisticated managers. The latter will buy the information for strategic analyses of such activities as buying new assets, acquiring other companies, or selling their own. In addition, they can use it to compile value-based financial statements that will help them close crucial disconnects between users’ needs and the obsolete contents of today’s GAAP statements.
We’re confident the opportunities for both parties are so great that this disruption can and will occur and that those who create it will get extremely wealthy. Reluctant managers who keep grousing about “costly” information will be left way behind by those who tap into these databases to provide truly useful financial reports to the capital markets.
This myth is going down.
MYTH NO. 8
“Unrealized losses are real but unrealized gains are not.”
Despite this myth’s preposterous second half, impairment accounting will remain generally accepted until accountants, academics, textbook authors and standard-setters finally awaken to its blatant inconsistency.
In our eyes, impairment accounting has one advantage and two flaws:
- Advantage: At least it puts some market values in financial statements.
- Flaw No. 1: It keeps substantially more market values out of the statements.
- Flaw No. 2: It doesn’t help managers, users, the markets or the economy.
Despite the flaws, it remains politically acceptable because auditors think it protects them against litigation.
As for us, we totally reject the idea that realization is essential for gain recognition because income occurs whenever values change, no matter what happens to cash.
Despite users’ needs for relevant information about both income and cash flows, GAAP income statements present garbled messages that commingle these two perspectives. Specifically, they disregard unrealized gains that actually occurred in the current period, while recognizing gains realized in the current period that actually occurred in prior periods. This useless mixed-up witches’ brew is not worth reporting.
A first step toward banishing impairment accounting will occur when forward-looking managers voluntarily provide auditor-reviewed non-GAAP disclosures of unrealized gains. A subsequent new requirement to move them into GAAP income statements should be a no-brainer.
MYTH NO. 9
“Market values cannot be safely audited.”
We point out that this myth had better be false because auditors already attest to impaired assets’ market values. In addition, they willingly audit acquirers’ combined financial statements that report market values of acquired companies’ assets and liabilities. If values are audited in these ordinary situations, surely they can be audited in most, even all, other circumstances.
For example, reporting acquirers’ assets and liabilities at their audited market values would produce “new basis” combined financial statements that reveal the whole truth, not just some of it.
We also shout out the stunning point that today’s audit opinions are at best warnings to users that they shouldn’t rely on GAAP statements because of their highly compromised contents.
In contrast, audits of value-based statements would enhance reliability and quality so much that wise managers would willingly pay higher fees to provide real assurance to the markets.
Therefore, we see substantial opportunity for auditors who abandon this myth.
MYTH NO. 10
“Reporting market values makes real income volatile.”
Like the others, this myth is completely untrue. Of course, value-based statements could initially lead to more volatile reported income by eliminating bogus smoothed results conjured with systematic depreciation and other policies that enable discretionary earnings management.
Nevertheless, we assert that value-based financial statements would be highly beneficial for two reasons. First, the amount of real income is relevant to users because it’s produced by real changes in real wealth. Second, unlike reported GAAP income, the amount of real income doesn’t depend on how it’s described.
Thus, income statements will be more useful when reported income comes much closer to real income and thereby provides more complete information about the latter’s amount and volatility.
Importantly, once managers choose (or are compelled) to report all value changes, they’ll quickly adopt a different mindset because, as we often say, “People manage what gets measured.” That is, when they comprehend that their real performance is reflected in a new kind of reported income that tends to converge on real income, they’ll grasp that having smooth real income is the only way they’ll have smooth reported income.
This shift toward transparency will motivate them to diminish real volatility by implementing new operating and financing strategies.
We like that idea, and so will the capital markets.
MYTH NO. 11
“Reporting market values makes stock prices volatile.”
To begin, we’ll note that a stock’s price volatility depends on the stability of the markets’ consensus about its real economic intrinsic value. For example, if most market participants agree that a stock’s intrinsic value is about $20, its market value will hover pretty close to that amount. On the other hand, a weak consensus will cause its market value to be volatile. Thus, if market participants’ estimates of a stock’s intrinsic value range between $10 and $30, its trading price is surely going to fluctuate.
Even a solid consensus on value can be rocked by unusual events that surprise the markets, such as takeover offers, election outcomes, geopolitical crises, and various natural and manmade disasters, all of which can actually change a stock’s real intrinsic value. When that happens, its market value destabilizes until the participants develop a new consensus.
Apart from those external forces, a volatile stock price can result from participants’ inability to develop a stable consensus because of significant uncertainty about the issuer’s future real income and cash flows. That uncertainty exists because today’s low-quality GAAP financial reports don’t provide the markets with adequately useful information.
Investors display two responses to this risk. On one hand, technical investors try to mitigate information-driven volatility through diversification and other forms of hedging.
In contrast, fundamental analysts dig deep into financial reports and other information to try to estimate a stock’s intrinsic value. While their efforts may help shrink the range of estimated amounts, that process is duplicative, expensive and time-consuming. Further, its results may not be sufficiently definitive to narrow the range enough to produce a nonvolatile market value.
However, if these analysts were to receive more useful public information through reliable value-based financial reports, they would be better informed, incur fewer research costs, and have more confidence in their estimates of real income and intrinsic value. Further, the market consensus would tend to stabilize around a narrower range because all the analysts could access the same information.
Ironically, we’ve shown that the actual effect of reporting market value information would be less stock price volatility, not more!
So far, we’ve dismissed 11 of the 14 myths that discourage acceptance for value-based financial statements.
Of course, even debunking all 14 myth won’t be enough to bring about substantive reforms because the real obstacle to progress is stubborn human nature. In particular, most people instinctively resist change, even in the face of overwhelming evidence that it’s needed.
Nevertheless, the existing financial reporting system desperately needs to evolve beyond its archaic and inefficient state. Despite today’s Internet-driven transparency and instant access to information, the present reporting system clings to the long outdated practices of releasing incomplete and opaque financial reports only once every three months.
This pathetic situation is ripe for transformation.
We think all these problems exist because most managers cling unwaveringly to two false premises:
- GAAP financial statement contents, especially reported earnings, determine share prices.
- Management can control share prices by using loopholes in GAAP to manipulate the statements’ contents.
Both are contradicted by today’s information-driven reality that secrecy and deception are ineffective and quickly exposed.
Clearly, managers will never maximize or stabilize their companies’ stock prices until they openly and more frequently tell the truth, the whole truth, and nothing but the truth. The sooner they reject their old ways and embrace new and more informative practices, the better off everyone will be. However, we fear most will just wait until the Financial Accounting Standards Board and the Securities and Exchange Commission tell them what they must do. Unfortunately, regulators are generally slow to grasp the need for change and even slower to implement it.
Therefore, we anticipate that innovation will come from information entrepreneurs in the hunt for an inefficient industry to disrupt. More power to them, and woe unto those who fail to seize today’s opportunities or remain oblivious to them.
Paul B. W. Miller is an emeritus professor at the University of Colorado at Colorado Springs.
Paul R. Bahnson is a professor at Boise State University.