A Discussion of the Consequences of the FASB’s failure to consider the effect of price-level changes on the Determination of Comprehensive Income
Wm. Bruce Schneider, Ph.D., CPA
Eno L. Inanga, MSc.
The Maastricht School of Management
John Rodi, MS(Accounting), CPA
California State University, Los Angeles, California
In 1993, a report titled Financial Reporting in the 1990s and Beyond was published by the Financial Accounting Policy Committee of the Association for Investment Management and Research (AIMR). Included in the report was a request to the Financial Accounting Standards Board (FASB) for a standard for comprehensive income reporting. Among the reasons asserted by the AIMR was a need for better reporting and understanding of the impact of changing fair values of marketable securities and all other nonowner changes in equity (Cope, Johnson, Reither 1996). The FASB considered the issue raised by AIMR sufficiently important to merit incorporation into its technical agenda on 13 September 1995. In June, 1997, it issued Statement of Financial Accounting Standards No. 130 (SFAS #130).
The statement requires an enterprise to:
Classify items required to be recognized under accounting standards as comprehensive income by their nature in a financial statement and
Display the accumulated balance of the comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position.
The Statement is significant for its several limitations:
It has not established any relevant set of guidelines to facilitate the measurement and reporting of “comprehensive income” in a manner consistent with its own definition of the term.
The document contributes hardly anything new to the determination of comprehensive income.
Although the FASB has suggested three possible formats of comprehensive income reporting, it has not indicated any preferred reporting format.
Most importantly, it has made no provision for reporting the effect of changing prices, which is arguably the single most significant, long-term factor affecting comprehensive income
For more than 65 years, the accounting profession has been reminded that inflation (one of the manifestations of changing price levels) affects the contents of financial statements. In 1932, before the establishment of the Securities and Exchange Commission (SEC), the legendary accounting theorist, W. A. Patton, admonished the accounting profession regarding its lack of attention to inflation hidden in financial statements prepared using historical costs:
It is evident that this whole problem [accounting for the effects of changes in price level] is an unsettled one, with much to be said on both sides. It is a question to be determined on it own merits with particular reference to the sound needs of business management and not on the basis of tradition. The accountant in general will do well to concentrate his attention on the development of methods of bringing reevaluations and their subsequent effects onto the books in a manner which will not impair the integrity of original cost figures, nor lead to the misinterpretation of financial reports, rather than take the position that the effects of revaluation are outlawed as far as accounting records are concerned. (Emphasis added.) [Wolk et al 1989, 389)
Inflation, the systematic decrease of purchasing power and destroyer of wealth, is a fundamental fact of economic activity over time and creates serious financial reporting and financial management problems. Deflation also creates serious valuation and decision-making problems; however, this phenomenon is seen less frequently. This paper will not focus on the measurement and reporting problems which result from the effects of changing prices. These issues, measurement techniques, and reporting formats are set forth in SFAS #89, Changing Prices: Reporting Their Effects in Financial Reports.
The Problem: We will concentrate on a more fundamental problem: the accounting establishment’s continuing lack of commitment to measure and report appropriate, relevant information for decision-making in a timely manner. The Jenkins' Committee Report documented that users believed that traditional financial statements do not meet their information needs. (AICPA 1994) That report and subsequent discussions have failed to yield significant improvements in reporting. SFAS #130 is but another example of the failure of the FASB to dramatically enhance the information value of financial statements. The Board’s “tinkering” with disclosure formats gives the illusion of progress, when in reality little or nothing of substance has changed. In the opinion of the authors, the Board is waging a losing battle by defending historical cost reliability, in the face of user demands for current relevancy.
The Financial Accounting Standards Board (FASB; Board):
The FASB has taken decisions over the past several years, which have not improved the usefulness of financial accounting reports, particularly with respect to the accounting for the effects of changing prices. In Statement of Financial Accounting Standards No. 89, Changing Prices: Reporting Their Effects in Financial Reports, the FASB effectively signaled that reporting these effects was not longer necessary. SFAS # 130, Reporting Comprehensive Income is totally silent on the reporting of the effects of changing prices. The position of the FASB appears to be seriously in error on both counts; and with respect to comprehensive income, in particular, the Board is unresponsive to its own definition of the concept. It has tinkered with disclosure, but it has not dealt with the issue of relevance.
This paper discusses the causes for and the implications of the Board’s failure to adequately consider the effect of changing prices on reported financial accounting information. The authors believe that the information value and decision relevance of price adjusted financial statements will be demonstrated within the context of the reporting of comprehensive income.
The solution to the problem of inadequate disclosure is not a matter of mechanics or cosmetic changes in formats, but rather is rooted in a change in attitude about what to report. This is in essence an ethics question. We will attempt to demonstrate, that in the complexity of intellectual calculus, it is more beneficial for the information market place to have relevant, albeit somewhat inaccurate information, than to have accurate, reliable, but irrelevant information.
It is the belief of the authors that in the face of systematic inflation, interrupted by occasional periods of deflation, the periodic transfer of historical, actual costs from the balance sheet into the income statement introduces irrelevant information into highly important contemporary decision-making contexts. The consequence is misleading or, perhaps, fraudulent disclosures that result in bad decision-making, quite inconsistent with the alleged purpose of financial reporting.
Organization of Paper:
The rest of the paper is organized in three sections. Section 2—Conceptual Issues-- introduces some of the fundamental theoretical concerns raised in past research. The authors remind academics and practitioners that several essential questions need further research and continuing consideration. Section 3—Discussion-- develops the problem and the implications of inadequate and inappropriate information for decision making. Section 4—Summary and Conclusion-- summarizes the authors’ argument for financial statements, especially the report on comprehensive income, to report the effect of changes in prices.
Several fundamental conceptual issues must be discussed before examining the behavior of the FASB. First we will clarify why accounting for the effect of price changes is so important in income determination and performance evaluation. We will briefly examine the accounting and economic concepts of income and finally we will look at what the Board said about the concept of comprehensive income and what its intentions were in writing SFAS #130.
Accounting for the effect of changing prices
There is a social need to provide people with information about economic wealth and real income, i. e., increase in wealth, as a result of the performance of entities and their managers. Our discussion is concerned with the importance of an adequately and appropriately designed structure for the disclosure of the elements or components of income. The following discussion is not about how to account for the effects of changing prices, but rather the usefulness of those measurements in building a comprehensive understanding of income for a period. The argument is based on several fundamental principles and observations.
The Social Setting and the Effects of Change
The problem of reporting the effects of changing prices is not unique to the US, nor is it unique to this period or point in time. The exchange of goods and services of value between individuals and entities has been a fact of the world's social history for centuries. The academic discipline within which the exchange process is studied is economics, one of the disciplines in the social sciences. Financial accounting is the practical language used to identify and describe economic events, measure the values in exchange, and report the cumulative effects of the economic exchange activities. The guidance is found in “generally accepted accounting principles” (GAAP). Many factors influence the nature and content of GAAP and because it is a function of unique national social contexts there are many sets of GAAP. The fundament factors shaping GAAP are described lucidly in Inanga (1994).
Accounting Measurement and Cost
Financial accounting measurement begins with cost, i. e., the price paid or exchange value in the transaction. A “price” can be understood as a monetary quantification of the exchange or economic value, i. e., fair value. At the instant of financial accounting measurement the following relationship pertains:
Price = Cost = Fair Value
In a market economy the determination and quantification of value are the culmination of a complex process which is dynamic. As a result, at a different time, the same relationship pertains, but the combined and cumulative effects of changes in society produce changes in prices. Thus:
The conversion or mapping function from time t-0 to t-1, etc. is very complex. Perhaps, it is not subject to precise formulation. Efforts to construct such a function belong to econometricians, not accountants. A general or specific price index can be understood as a proxy for the function, plus provision for error, because an index is not completely efficient. There is no question that the index or mapping function is imprecise, but that does not mean that it is necessarily wrong or significantly in error.
The Problems of the Mapping Function
The value today, expressed in monetary terms, reflects the effects of the social, political, economic, regulatory, and technological (SPERT) forces producing changes in the environment. The probability is very high that the effect of the SPERT factors will, in fact, produce a change in apparent value, i. e., the price of goods and services. The significance of that change in terms of real wealth can only be measured or estimated by making a comparison between today’s values and a set of values established at some point in the past, i. e., the monetary amount recorded by accountants, adjusted for the effects captured in the SPERT function. To properly evaluate and understand the causes and implications of the changes in reported values between periods, the past must be restated (estimated) in terms of the values found in the SPERT related mapping function. That is it is necessary to remove from reported income the effects of changes unrelated to entity or management performance.
The Risks Inherent in the Use of Indices
The use of an index is inherently risky for several reasons. As noted above, the mapping function is extra-ordinarily complex and, perhaps, it is not definable with the degree of certainty deemed necessary and appropriate by accountants. Additional errors may be introduced by the fact that exactly the same goods and services may not be available for comparison at a later date. Also, goods and services, when combined in an entity by a specific management, may have a value that is greater than or less than the prices paid for them individually, i. e., implicit goodwill.
Another less technical, but significant problem is: who is going to select the index or assign the adjustment factor in a specific situation? The answer lies in understanding who is responsible for the outcomes and the consequences in terms of the legitimacy of the restated values. Accountants see this as part of the reliability versus relevance debate.
The Importance of SFAS #89
A reality check is needed here. The Board, in SFAS #89, has specified the criteria and adjustment process, but it has not required that it be used. Sophisticated financial statement users know that price level changes have not been reflected in the financial statements. As a result they either estimate the effects or they by-pass the financial statements and analyze nominal cash flows. Several academic colleagues in Finance and a CPA, private portfolio manager, have said, “We live in and make decisions about a world of market or fair values, not the historic past of the accountants.” In either case, the work of financial accountants, based on generally accepted accounting principles unadjusted for the effects of changing prices, appears irrelevant.
Thus, for the accountants the consequence of using a mapping function with a value of zero results in a perceived information gap that damages or destroys the alleged usefulness of financial statement. If users make the adjustments, they may lack the technical knowledge of both the adjustment method and, more seriously, the most appropriate adjustment function and/or factors. In either case the outcome is wrong information.
The authors suggest that accountants within reporting entities, working with management, can and should develop mapping functions and adjustment factors that relate well to the unique characteristics of the entity’s economic activities. The authors believe that the information marketplace is capable of evaluating the decisions of management and rewarding competence in developing price-level adjusted financial information that is reliable and relevant. These issues and problems produce significant opportunities for need based accounting research.
We now turn our attention to the problem of income determination.
The ideas, concepts, and relationships discussed above are central to a discussion of income.
The following comments are based on the authors’ general understanding of accounting and key ideas about income summarized and presented in Elliott and Elliott (1999).
Accounting income--Accounting income is the difference between revenues and expenses (expired costs). This computation presents accounting income simply as the periodic change in the book value of an enterprise, excluding any investment by owners and dividends paid to owners. In other words, income is defined strictly in monetary terms. It is generally understood and believed that because the difference is calculated based on accumulated data related to real events, measured at cost--the monetary value or price of the resource flows at the time, it is objective and verifiable, i. e., reliable.
The problem with this relationship is that revenues, i. e., what you get for what you do, are measured at current market, while the costs, i. e., what you paid for what you do, are historic and may or may not be closely related in time to revenue. If a major component of cost is amortization or depreciation, or if what is being sold is the result of costs incurred in a distant past that have been fully written-off, there is likely to be a significant difference in the purchasing power of the monetary amounts in the difference equation. Thus, because of the timing of recognition of costs, there maybe a significant violation of the matching concept. In a sense, it is like comparing apples and oranges. Both are fruits, but there are fundamental differences in the nature of the items compared. In historic cost accounting this difference is hidden by the use of a nominal monetary unit that is incorrectly (harmfully?) assumed to be constant over time in terms of its purchasing power.
In recent years, however, the need for values that reflect current market conditions, not the market values/conditions at the time of initial recording, has affected reported values. Generally, but not always, market re-valuations have been downward from the initial amount, not upward. This is the practical expression of conservatism in accounting practice. For example, inventories are reported at the “lower-of-cost-or market” with a loss of value taken directly into the current period income statement.
In recent years, the valuation adjustments related to several specific transactions and events have been reflected as “line item” increases or decreases in equity because these “losses and recoveries” have been deemed to be “unrealized”, but not unreal, changes in balance sheet values, which will ultimately be determined at some time in the future when they are realized. It is these items that SFAS #130 deals with and will be identified during a review of that document. On an overall basis, the current accounting model uses a mixture of cost and fair value measures that produces a blended picture of entity and management performance and status.
EconomicIncome—The general economic concept of income was defined by Sir John Hicks (1946) as “…The amount which a man [woman] can consume during a period of time and still remain as well off at the end of the period as he [she] was at the beginning…” suggests that income is the difference between the present value of beginning economic values and the present value of current economic values. In other words, income is defined in terms of real wealth. The value today, expressed in monetary terms, reflects the effects of the economic, social, political, regulatory, and technological (SPERT) forces producing changes in the environment. The probability is very high that the effect of the SPERT factors has, in fact, produced a change in apparent value, i. e., the price of goods and services. The significance of that change in terms of real wealth can only be measured or estimated by making a comparison between today’s values and a set of values established at some point in the past, i. e., the monetary amount recorded by accountants adjusted for the effects of price level changes.
To properly evaluate and understand the causes and implications of the changes in reported values between periods, the past must be restated (estimated) in terms of the values found in the SPERT related mapping function. The change in a price, that is a change in value, may be an expression of change in wealth. These changes, when brought to present values and accumulated, comprise the economist’s operational definition of income. Therefore, in order to understand and measure income, i. e., the change in wealth, it is necessary to measure and report the individual and accumulated and cumulative effects of changes in prices. That is it is necessary to remove from reported results, the difference reported as income, the changes unrelated to entity or management performance.
The Ultimate Purpose of the Comparison
The ultimate purpose of the comparison is to measure effects of the principal-agent relationship produced by the actions of resource owners and their agents—management—and the entities using those resources. In other words, reporting the effects of changing prices is essential, because the information required for resource management decision-making and for entity and manager performance appraisal should be seen, evaluated, and understood without effects unrelated to performance. The current mixed value model does not provide appropriate information.
The failure to measure and report the effect of changing prices means that the measure of wealth—existing and changing—is inefficient, ineffective, and misleading. For example, holding gains are buried in income when realize. The reported performance is not a measure of management or entity performance, but rather the effect of recognition timing. Knowing this, it could be asserted that GAAP financial statements, unadjusted for price level changes, are fraudulent.
Thus, economic income is a measure of the cumulative effect of all events and consequences that affect economic value measurements, brought to present value, during a period of time, i. e., between measurement points in time. In general this approach is an attempt to eliminate the effect of changes in values unrelated to real value creation—a more relevant, realistic, “true and fair view.”
Since economics is not tied to past valuations, i. e., fair value at the date of the economic event, as is accounting, the arbitrary transfer of historic costs into the income determination process does not affect economic income measurement. Economic income is concerned with exchange transactions: their market value consequences and cumulative effects reported at present value. Economic income is a cumulative difference measure, like accounting income, but the factors affecting value change are far more complex than the simple accounting measure. Economic income includes many subjective valuations, which lead accountants to raise a set of legitimate and valid questions:
Where did the economic values come from and how objective and verifiable are they?
What is the reliability of the reported difference?
What time periods and interest rate factors were/should be used to determine present values for measuring the incremental change?
The heart of the comprehensive income reporting problem and the larger dilemma of the financial accounting establishment is: what is income? A change in wealth or a simple, arithmetic monetary difference.
The conflict—historical cost versus fair (current) value
The discussion above highlights the fundamental conceptual conflict: Is income best measured using the accountants’ historic cost approach (in monetary terms) or is the economists’ fair value approach (in real wealth terms) the best. As indicated earlier, there is a link between the two. The difference between the two valuation schemes is not whether the values or amounts reported are a fair or market value. Both are/were fair values. The problem lies with what to do about the mapping function, which is a consequence of time. The conceptual conflict leads to several questions: Which measure is more relevant, to whom, for what purpose(s), and how important is a relevant measure versus a reliable one? Who is in the best position to estimate the values produced by the SPERT mapping function? Is a general price index (PI), a specific CPI, or any PI sufficiently robust, stable, and conceptually defensible to be used generally?
Different answers to these questions, based on legitimate and defensible alternatives, yield significantly different policy decisions and GAAP statements. The purpose of this paper is not to answer these questions. But rather the authors wish to remind academic and practicing accountants that serious research needs to be done with respect to these questions and that hard decisions are needed.
The Ultimate Question
The ultimate question is: Is the traditional, conservative approach to answering these operational questions and to the setting of accounting and reporting policy appropriate for the information and decision making environment of the 21st Century? The authors suggest the answer is “NO” and the discussion of and reporting of comprehensive income brings the issue to the fore.
SFAS #130—Comprehensive Income
The following part of this discussion is based on SFAS #130. It is essential to understand the position taken by the FASB in order to appreciate the concerns expressed by the authors.
Comprehensive Income—the FASB viewpoint
Of necessity a rather extensive quotation from SFAS #130 is required to set the context for the discussion.
Definition of Comprehensive Income
Comprehensive income is defined in Concepts Statement 6 as ‘the change in equity [net assets] of a business enterprise during a period from transactions and other events and circumstances from nonowner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners’ (paragraph 70).
In Concepts Statement 5, the Board stated that ‘a full set of financial statements for a period should show…Financial position at the end of the period, earning (net income) for the period, comprehensive income (total nonowner changes in equity) for the period, cash flows during the period, and investments by and distributions to owners during the period’ (paragraph 13, footnote references omitted)….
Use of the Term Comprehensive Income
This statement uses the term comprehensive income to describe the total of all components of comprehensive income, including net income. This statement uses the term other comprehensive income to refer to revenues, expenses, gains, and losses that under generally accepted accounting principles are included in comprehensive income but excluded from net income….
(The reference is to the following existing SFASs: #52, Foreign Currency Translation; #80, Accounting for Futures Contracts; #87, Employers’ Accounting for pensions; and #115, Accounting for Certain Investments in Debt and Equity Securities which have required certain valuation changes/adjustments to be reported in the Equity Section, rather in current period net income.)
Purpose of Reporting Comprehensive Income
The purpose of reporting comprehensive income is to report a measure of all changes in equity of an enterprise that result from recognized transactions and other economic events of the period other than transactions with owners in the capacity as owners…. (Emphasis added)
If used with related disclosures and other information in the financial statements, the information provided by reporting comprehensive income should assist investors, creditors, and others in assess an enterprise’s activities and the timing and magnitude of an enterprise’s future cash flows. (Emphasis added)
Although total comprehensive income is a useful measure, information about the components that make up comprehensive income also is needed. A single focus on total comprehensive income is likely to result in a limited understanding of an enterprise’s activities. Information about the components of comprehensive income often may be more important than the total amount of comprehensive income. (Emphasis added)
The ideas expressed, as highlighted, create an expectation that the FASB will take a truly “comprehensive” view of what should be included and reported. However, SFAS #130 merely provides for the rearrangement of the display of valuation change adjustments, which were previously defined and measured by GAAP. Nothing new or different has been prescribed in terms of the identification, measurement, or reporting of income. Nothing has been changed that improves the ability of users to predict cash flows. And little has been done to improve user understanding of the current and cumulative effect of the items disclosed on enterprise income. Certainly the effect of changing prices is an economic event that affects income in its broadest meaning, impacts the prediction of future cash flows, and is important for users to understand as a component of comprehensive income. In the final analysis, income, net or comprehensive, is still reported using modified historical costs in the traditional financial accounting manner.
A brief exploration of the meaning and implications of the “comprehensive” will be helpful in clarifying the causes for the expectation that the document would be more useful. (The concept of income in terms accounting and economic theory and measurement were explored above.)
Comprehensive—The Word and Its Implications
The word “comprehensive” as commonly used communicates the idea that whatever follows is meant to be understood as “complete; including nearly all elements, aspects….” (Oxford 1990) This implies, in this case, that income is to be reported in an all-inclusive manner, with nothing of significance omitted. The Board on the one hand expressed the intent is to provide for the inclusion of other significant economic events in the measurement of income; but it in fact limited the events reported only to actual, historical transactions that have been recorded in accordance with SFASs # 52, 80, 87, and 115 identified above. This was a “safe” position. However, what is reported is only part of the story of income; it is not complete or “comprehensive.”
The Expectation Gap
The FASB in the title of SFAS #130 creates expectations in users. However, the hoped for information is not forthcoming. The promise is not fulfilled. For over twenty years US accounting literature has reflected a concern that financial accountants, GAAP, the accounting process, and the resulting statements do not meet user needs and expectations. ( For example: Anthony 1991; Wallman 1995, 96a&b, 97; Schneider 1997; Leadbeater 1998.) SFAS #130 is an example of the FASB’s recent contribution to the “expectation gap” problem.
It cannot be successfully argued that the Board met its objective as expressed in paragraph 11 of SFAS#130. What emerges from the discussion is the realization that the Board has chosen to define or use the words “comprehensive” and “income” in a manner inconsistent with normal usage and the needs of society for relevant and reliable information. The Board because of its position on reporting the effects of changing prices, as set forth in SFAS #89, has effective foreclosed its options. The Board chose historic reliability over current relevance.
The apparent reasons for the Board’s position on accounting for the effects of changing prices and the implications and consequences for income determination will be developed in Section 3.
The output of the traditional financial accounting process constitutes much of the input used in economic analysis, fiscal and monetary policy-making, and financial management. It is ironic that a process, which by design, is deficient and defective plays such a central role in the world economy. As noted in the prior section, the key weakness lies in the traditional financial accounting measurement of income. The failure to consider the effect of changing prices contributes significantly to the measurement problem.
The US Accounting Establishment
The United States accounting establishment, consisting of the FASB, the Securities and Exchange Commission (SEC), the Emerging Issues Task Force (EITF), the American Accounting Association (AAA), the American Institute of Certified Public Accountants (AICPA), and “Big 5” public accounting firms with contributions of the AIMR and other professional groups, has devoted considerable resources to issues related to financial accounting and reporting. The US is generally considered to be the world leader in accounting research and the development of accounting theory and practice. However, in its successes and strengths are also found its failures and weaknesses.
Value Changes—The Consequences of Denial
A curious parallel exists between the effects of changing prices on income and wealth measurement and the effects of changing information needs on the usefulness of accounting reports. Economic wealth is damaged or destroyed when the effects of changing prices (values) are not properly identified, measured, and reported. Likewise the value of accounting, as the “practical language of economics,” is damaged or destroyed when changing user needs (values) are not appreciated. In both cases, denial of the importance of value changes leads to disaster.
The Roots of the Problem
The position of the accounting establishment with respect to accounting for the effect of price changes and user demands for better, more relevant financial information is understandable. Its lack of a proactive response is rooted in the relative success of the profession and the historic cost model.
Few models, expressions of relationships, have withstood centuries of use as well as the double entry model attributed to Pacioli. It is based on a relatively simple, straightforward set of assumptions and principles, which have provided stability and critical values for its operation. But therein lies the weakness. The needs, so well served for centuries, have changed, but the assumptions and principles have remained effectively the same.
Of particular importance to this discussion is “conservatism” which essentially is a behavioural imperative. A second critical dimension is a value driven choice that places reliability ahead of relevance in terms of information attributes. The consequence is that the accounting establishment is biased in favour of the status quo psychologically and, furthermore, it finds comfort in reporting what can be verified which reflects the audit experience bias of most professional accountants. The affective problem is that these long held values result in inadequate responses to current and emerging problems.
A Paradigm Shift
Today information is consumed at such a high rate that the marketplace cannot wait for it to be “true and fair” in the parlance and tradition of the accounting profession. The alternative of “quick and dirty” is also not acceptable. Possibly there is something to be learned from the discipline of statistical process control. That is, the design of the accounting process and the rules for its operation need to be examined and revised or redesigned to minimise production errors. The ongoing focus then shifts to the control for errors.
This type of shift, a paradigm shift, also affects the way users of accounting information understand the accuracy and, therefore, the arithmetic reliability of accounting reports. Any number in an accounting report, even with the qualification that it represents a “true and fair view” or “fairly presents,” implies a degree of accuracy and certainty that is not possible to achieve and cannot be achieved with the accounting process. The audit report is naively believed by many users to indicate that the numbers are what they purport to be in an absolute sense. The accounting establishment’s dogged determination to report reliable information contributes to the perceptual problem.
There has been a paradigm shift at the user level. The Jenkins’ Committee Report (1994) documents this. Sophisticated users ask for traditional financial statements because there are no other formal reports available. But their usefulness is problematic, not because they are unreliable but because they lack relevance. Even the best reporting reflects old information, at historic cost, that does not relate well to the needs of the moment and future.
The Theory of Income--FASB
A review of the theoretical discussion in SFAS #130 is indicative of the problem. The discussion of income measurement and disclosure theory provides an interesting retrospective on accounting approaches. It does not venture into economic theory as was discussed earlier in this paper. The information users, the decision-makers of today, live in and make decisions about today and tomorrow. Accounting theory and practice that is driven by traditional conservative values, including a pre-occupation with reliability at the expense of relevance, does not serve the social need. SFAS #130 is tragically flawed for this reason.
Incentives and Motivation
There is little current incentive for the accounting establishment to behave differently. For example, the current rate of inflation in the US and much of the Western world, a cause for changes in price levels, is very low and has been for several years. There is no perceived need to report the effect of changing prices. Therefore, the approach to reporting has been low key and non-directive. However, for most of countries rapid change in prices is in fact important at the national level and, because of international trade and investment, it is becoming a world class financial and economic problem with significant fiscal and monetary policy implications.
This paper was motivated by concerns about the lack of adequate reporting of the effects of price changes and the consequent impact on decision-making at the public policy, capital market, and entity operating levels. The Board’s reluctance or unwillingness to require price adjusted reporting seems to be rooted in its history. The process of adjusting non-monetary asset values from historical cost to, for example, a current cost, constant dollar basis is somewhat complicated and does require the use of estimates and price level adjustment indices. The errors to be controlled for, as suggested above, relate to the appropriateness of the indices used for mapping to present value by the preparer. Additionally, the user must control for inappropriate use and reliance. Perhaps overall preparer liability would decrease if reported information was understood to be indicative and likely to be relevant, not arithmetically accurate and presumably reliable.
The importance of economic and financial decisions requires that the best information be used, even if is less reliable numerically, but more relevant. There is a value choice or tension between what can be readily verified, i. e., historical cost, and probable current value that is a function of approximations.
The Essential Question
The essential question is: Is it better to have the correct historic cost measurement that is irrelevant or a “scientific guess” with some probability of error but higher relevance. The calculus is not obvious and the answer is clearly a matter of professional judgement. However, the seriousness of the consequences of the choice cannot be minimised, nor can the difficulty in making the choice be underestimated.
It can be safely inferred from the above that the authors believe there are significant challenges to the Board’s and accounting profession’s long held beliefs about the principles used to identify, measure, and report economic information for decision-making affecting the future. Furthermore, the authors believe the information value of accounting reports would be increased if the most highly valued attribute was relevance, rather than reliability, and the focus was current economic value, rather than historic cost.
Practical Insights on Error Control
Recently one of the authors discussed the problem of uncertainty or lack of precision and verifiability of information about a present and future condition with a consulting environmental engineer. He observed that in his field timeliness has taken precedence over certainty, i. e., relevance versus reliability. He said, “Many of the problems we are dealing with are so critical that we simply can’t wait to get all the data, to know exactly and completely what is going on. We begin action when we have a reasonably good idea of what the situation is. It is rare that we have 70% of the data ultimately required when we begin. This means, however, that we must look for indications that our original assessment was incorrect and that changes or adjustments must be made. There is waste, but the benefits of timely action out weigh the costs of delay and misdirection.” There are several practical lessons to be learned from this comment. Decision-makers in dynamic contexts do not, because they cannot, wait for all the information. They are willing to work with partial, but relevant data. They are sensitive to the inherent weaknesses in the information and control their actions accordingly. In other words, the nature of the decision context and the nature of the data affect the responsibility assumed by the decision-maker. They make few if any assumptions about the inherent absolute reliability of data.
The Time for Beginning is Now
Since prices are not changing rapidly in the US at this time, this is a good time to experiment with reporting the effects of changing prices. The current price for “getting it wrong” is probably relatively low. The reporting of comprehensive income using “economic income” as the operational definition would provide a meaningful starting point. The techniques, attitudes, and behaviors needed to manage the inherent risks in measuring, reporting, and decision-making related to relevant rather than reliable financial accounting information need to be developed
Summary and Conclusion
If the Board is concerned about reporting a comprehensive income measurement that is truly comprehensive, meaningful and useful, it is difficult understand the omission of reporting the effects of changes in prices. Furthermore, if the Board is really interested in improving the usefulness of financial statements, it is absolutely necessary to provide users with some idea of the relationship between the historical cost and the price/value-adjusted basis of assets. Additionally, it is the management of an entity that has the best information about the most appropriate mapping function(s) to use. It also has a vested interest in getting the disclosure “right,” because the information marketplace has the capacity to evaluate the competence of management administering rewards and punishments as appropriate.
It must be noted that the Board in recent years has adopted valuation approaches for some assets that bring those reported values closer to current value, rather than adhering to a strict historical cost model. Financial statements that reflect assets reported at market, net realisable value, and possibly current cost and/or constant dollar are essential to public policy makers, investors and lenders, economists, and others who make decisions that shape the future. The current statements are a “mixed bag” of values with significant recognised assets mis-reported and hidden holding gains that distort entity and management performance when realised. SFAS # 130 suffers from the same problem that plagues virtually all financial reporting: a preoccupation with reliability, rather than relevance.
The Board must move beyond its rigid demand that the values reported be objective and verifiable, i.e., reliable, to a concern about timeliness and credibility, i. e., relevance. A fundamental change in attitude about what is important and a clear commitment to meeting users information needs is required. The accounting establishment’s continued denial of both will result in a loss of its social imperative. It too will become irrelevant.
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