The PCAOB misses the main point – by a mile

Implications: The shortage of value–based accounting expertise is real, but only in the sense that financial reporting practice is poised on the brink of a new era in which the volume of useful information is about to increase dramatically.  The issue is how to get more people into the pipeline who understand that value-based reporting is not a hazard to be avoided but an opportunity to be seized.  The ultimate outcome will be financial reports that are actually useful and, as such, more valuable for those who consume them.  And that means more income for auditors and accountants alike.  What, then, is the basis for the fear that more value-based reporting seems to create for them?

Analysis: In reading Sarah Johnson’s article, it was clear to me that she missed the main point about the transition to more value-based reporting.  Then, because it is probably true that most of what she knows about value-based reporting came from the PCAOB, then perhaps they, too, have missed the main point.  And, if the PCAOB is missing the point, then a great many practitioners (managers, accountants, and auditors) are also going to miss it.

For example, I think many will latch onto the news of a shortage of expertise in auditing values as a justification for not using these numbers in financial statements.  If so, that would be a poor decision.  By analogy, when computers were being introduced into accounting, there were shortages of programmers and auditors who knew what to do.  Where would we be if everyone had dug their heels in and said there was no good reason for making the transition?

This particular expertise is an economic commodity, and it should be no surprise that the demand for it exceeds the supply.  The solution to the shortage is in letting the market work:  those who want experts will have to pay higher compensation to get them, and that incentive will create a great many new experts, and equilibrium will be reached, sooner or later.  What is painful to watch is that the accounting profession, including its education branch, has not seen this demand coming.  It’s as if they’ve been in denial that anything is wrong with the status quo.  

For example, I was bemused to see that the authors of the standard text book I use in my Intermediate Accounting class simply deleted the section on value-based reporting in their recent new edition.  Because textbook content is driven by the instructors who teach from them, it appears that my colleagues don’t see the main point, just like the PCAOB.

Uncertainty: more or less?

Further, it would appear that the PCAOB staff doesn’t understand an important concept about the nature and purpose of financial reporting.  As paraphrased by Sarah Johnson in her column, they believe “that the increased use of estimates based on market value — rather than historical cost — adds uncertainty and subjectivity to financial reporting and an added risk of material misstatements.”  

I contend that this assertion is DIAMETRICALLY opposed to reality.  The error arises from their adopting the perspective of those who supply financial statements, not the point of view of those who use them to support decisions.

If it’s true that fair values contain information that reflects the present cash flow potential inherent in assets and liabilities, and if it’s true that historical costs contain information that reflects their past (even long past) cash flow potential, then any increase in the quantity of value-based information will greatly INCREASE the usefulness of financial statements by actually eliminating a great deal of the uncertainty created when obsolete cost-based information is presented.

If you were to be making a rational decision on whether to keep an asset in production in your company, would you want to know what you could get if you sold it or its original cost minus systematically (and subjectively) compiled depreciation charges?  Or, if you were presenting financial statements to potential lenders, would you want them to base their proposals on what your assets are worth today or what they were worth years ago, minus accumulated depreciation?  In the same way, would you want the capital markets to be valuing your stock on the basis of precisely calculated but totally uninformative book values or on their approximate fair values?  

What does it say about our cost-based reporting system if the worst thing that could happen is that those who use our reports actually believed the numbers reported on them?

Auditors don’t know fair values?

And, as for the assertion that auditors don’t know how to deal with fair values, it, too, is patently false.  Auditors have dealt with values for decades and done right nicely with them.

Consider that purchase accounting for business combinations has always been based on the fair values of the acquired company’s assets and liabilities.  Auditors have performed their testing and reached conclusions quite comfortably in these situations.  Why couldn’t they apply the same tests and procedures to the values of assets and liabilities of the acquirer?  And, for that matter, why couldn’t they apply them to the assets and liabilities of a company that is neither an acquirer nor an acquiree?

Furthermore, auditors have had absolutely no problem dealing with asset values when they have fallen below their book values.  Back a long time ago when I worked at FASB on the original Conceptual Framework, we were bemused even then at those who thought value is perfectly reliable for impaired assets but totally unreliable when it is higher than book value.  The board itself has clung to that lower-of-cost-or-market thinking into the modern era with its standard (SFAS 144) on writing down impaired assets but not writing them up.  

In any case, where were the auditors’ objections to the subjectivity and uncertainty of these lower market values?

Here’s the answer

My bottom line: The shortage of value–based accounting expertise is real, but only in the sense that financial reporting practice is poised on the brink of a new era in which the volume of useful information is about to increase dramatically.  The issue is how to get more people into the pipeline who understand that value-based reporting is not a hazard to be avoided but an opportunity to be seized.  The ultimate outcome will be financial reports that are actually useful and, as such, more valuable for those who consume them.  And that means more income for auditors and accountants alike.  What, then, is the basis for the fear that more value-based reporting seems to create for them?