Harvey Kapnick

by Humphrey Nash

The following quotes are from a paper by Harvey Kapnick former council member of the AICPA.   There will be a quiz at the end of these quotes.

"Accounting based on values has been discussed more during the last forty years by accountants as providing more useful data based on economic facts than any other subject. Yet, what results in practice do we have to show for all these speeches, articles, papers, and books? Almost nothing! Why has there been so little real progress when an obvious need for change has become increasingly evident for many years?

While the accounting profession has had its share of inertia and problems, it has also lost great opportunities for service. The leadership in the profession has been ineffective in getting accounting standards in the United States on a sound conceptual basis. Further, business leadership, government regulators, and others have not persuaded the accountants to become realistic in reporting the economics of business operation. Confusion and a lack of realism have been the result."

"The rate of change in the way business is conducted has accelerated greatly in recent decades. Today, there are large corporations (including multinationals and conglomerates), complex income taxes, lease financing, pension plans, an energy crisis, electronic computers, and transfer prices. The present business scene includes not only these but also many other far-reaching developments, plus a maze of governmental regulation, a rapid rate of technological change, world-wide inflation, and a perceived need for public financial reporting that encompasses ever shorter time intervals, i.e., quarterly.

Being man-devised and man-implemented, accounting should be expected to adjust to such changing conditions, as do social behavior, ethical standards, and the common law. However, since most individuals are disposed to resist change, a tendency exists, without some overriding force, for changes to lag behind the need. After making allowance for what might be described as a normal lag, accounting still is so far behind the rate of change that has occurred in the environment in which business operates that it is a source of embarrassment. How can our watchwords, "generally accepted accounting principles," receive high marks for providing relevant financial information when the business environment has changed so much in recent decades while accepted principles have changed so little?

"An enormous investment of time and resources has gone into the quest for uniformity. This effort has essentially been within an outmoded conceptual framework, and the goal of revising and reformulating accounting principles to better meet the needs of a changing business environment has, for all practical purposes, been lost in the shuffle. Uniformity as a goal within the historical-cost framework may by hindsight have been an unfortunate decoy."

"The efforts of the accounting profession to improve accounting standards and principles have been dominated by CPAs in public practice, and the auditing aspects of problems have always been a significant consideration to them. When useful information for investors is our goal, what is easiest to audit may not be the most useful."

"Accounting has suffered from a void attributable to a lack of agreement about the objectives of the accounting and reporting process. This subject has not been raised much above the level of an academic exercise. This lack of agreement with respect to objectives has seriously handicapped efforts to resolve accounting problems and controversies. Objectives, authoritatively supported, could provide the goal, the road map, the unifying force, and the direction needed to stimulate the process by which accounting standards could become relevant and result in truly meaningful and useful financial statements.

... the Financial Accounting Standards Board since its inception in 1973 has dealt with various subjects without any established objectives.  This continuing delay is becoming increasingly intolerable, resolution of this matter in the foreseeable future cannot be predicted with much confidence.

"Economic resources are defined as those elements of wealth that possess the three basic characteristics of utility, scarcity and exchangeability, which in combination give the resources economic value."

"The basic characteristics prescribed for economic resources tend to exclude the wide assortment of unidentifiable intangibles or attributes of a business enterprise that may give it an advantage over others in a relatively free, competitive economic system and, hence, enable it to achieve earnings beyond a normal rate of return on capital. The attributes of unidentifiable intangibles may be extremely valuable -- they may arise through deliberate effort or accidentally -- but information about their quality and potential value should be conveyed primarily by earnings information rather than through direct measurement and inclusion in the balance sheet as assets.

A value-based approach also determines the companion earnings concept. If earnings are based on the measurement of economic resources, then periodic earnings will be determined by the change in the owners' equity shown by comparative balance sheets, after a provision for the maintenance of owners' capital to reflect the effects of inflation and after allowing for additional investments by owners and distributions to owners. In other words, the earnings concept is ultimately based on changes in the value of the net assets. However, unless inflation is taken into consideration, much of what is traditionally viewed as income may not exist in real terms. Thus, making a provision for capital maintenance in terms of purchasing power should be a key factor in income measurement."

An observation made many years ago by one of my former professors, W. A. Paton, is still very pertinent:

"...it is really values that are the basic data of accounting, and costs are important only because they are the most dependable measures of initial values of goods and services flowing into the enterprise through ordinary market transactions."

  

"Value Concepts Readily Understandable

The kind of fundamental change that deserves attention is a major shift to value accounting. Such a move does not require accountants to settle on one particular value concept now as the best for all or in developing different value concepts, but reliance on a single value concept will probably never be desirable. The value concept used should be one that offers the prospect of indicating the most relevant approximation of an asset's value, taking into consideration such factors as feasibility and verifiability. Because there has been relatively little use of value data in accounting, the practicing accountant has not been really challenged to search for evidence about values. More verifiable support for value information probably exists than is generally believed.

The cost basis is frequently defended by pointing out the complexity of value concepts and the extensive differences of opinion that exist about values. Cost is not greatly different from value in this regard because cost concepts are also complex. There can be many differences of opinion about the computation of cost. Not only does cost-based accounting result in differences of opinion about the initial recording of cost but, in the case of depreciable assets, estimates must be made about useful life and salvage value. Hence, there is introduced into our present system of accounting the opportunity for using a variety of amounts in accounting for similar, even identical, assets. In other words, differences of opinion will exist in accounting whether it is cost-based or value-based.

...

It would be inappropriate to generalize very much from this limited research. On the other hand, this research illustrates what I believe to be true, that sweeping assertions to the effect that value ranges would necessarily be wider than amortized cost balances are not necessarily valid. Accountants rely so much on cost concepts and cost computations that they tend to lose perspective about how much complexity and estimation are associated with the application of cost-based accounting.

Value-based accounting is really not radical. Considerable reliance is presently placed on value in the application of the lower of cost or market approach to inventory valuation and the net realizable value test for various assets. Managements regularly work with and are concerned about values. Many knowledgeable people consider the present-day balance sheet as being of limited usefulness because it conveys so little meaningful information.

Where Are We and Where Are We Going

Where are we and where are we going? The first part of the question is easy to answer. We are in a conceptual mess. With respect to objectives and basic concepts and with respect to considering the best way to reflect economic realities as they exist in business enterprises, the FASB has displayed no effective leadership.

The second part of the question with respect to where we are likely to go is much more difficult to answer. How much can be done on a piecemeal basis? What should be supplemental information and what should be shown in the primary financial statements? Would price-level accounting prove to be a step toward value accounting? Can anything in this regard be done without first establishing objectives?

This leads to the question -- do we now need evolution or revolution? For many years, I favored evolution based on sound objectives because this would seem to be the orderly and sensible way to achieve progress. However, the accounting profession has procrastinated for so long that the time for evolution has been frittered away.

Therefore, this bicentennial year would be a good time for a major change in our approach to accounting -- a rededication to establishing appropriate objectives to reflect economic realities. Let us not be satisfied with piecemeal and half-baked efforts to dabble with our accounting problems. Let us not be lulled into a sense of false security by complex disclosures and other superficial and confusing patches. While the accounting profession proposes education for investors so they presumably can better understand what is turned out by accountants, I propose that we first produce financial statements that present the facts in as concise, clear, and understandable manner as possible.

What is needed so much as soon as feasible is a value-based system of accounting supported by sound objectives and implemented by consistent and coordinated standards, This should be accomplished in the primary financial statements and not by complex supplemental disclosures, additional columns in the financial statements, or by other patches on an outmoded approach."

Quiz 

What is the blacked out portion in the penultimate paragraph?

The answer is icentennialbay earyay.  Kapnick remarks have improved with age.  They are even more pertinent today than they were a quarter of a century ago!  The full text of his remarks is available at,

http://newman.baruch.cuny.edu/digital/saxe/saxe_1975/kapnick_76.htm

There are two additional points that Kapnick makes which conflict with the AFTF model of value based accounting and it is important to illuminate these since they solve practical problems in implementing value based accounting.  Kapnick writes,

"Confusion constantly arises between changes in value and changes in purchasing power. The fact is both are occurring and, while there may be an interrelationship, the effects of each should be accounted for separately. Thus, the debate concerning whether value accounting or price-level accounting should prevail is not on point, because in the long run both should prevail. The real changes in value should be segregated from changes resulting only from changes in price levels."

Separating real from inflationary value changes is extremely difficult.  With AFTF this is not necessary or even desirable.  First, we note that AFTF employs a purely prospective valuation model.  This eliminates the effect of inventory valuation.  Second, the historical cost of capital incorporates provision for past inflation and future inflation in a balanced manner, at least to the extent of capital market judgments.  These judgments are backed by investors strongly motivated to be right and are customized to the effects of inflation on the particular company. 

Kapnick writes,

"The function of financial accounting, in our view, is not to value the business as a whole, but rather to convey value information about the economic resources of a business.  This distinction recognizes the need to segregate the accounting function from the investor function."

Specifically Kapnick states that,

"Failure to observe this segregation of functions in the past has introduced a circularity that has reduced the usefulness of financial information and has resulted in great confusion in the resolution of individual accounting problems (e.g., goodwill) and in growing confusion over responsibilities for financial forecasts."

and that,

"Making predictions and reaching economic decisions are the responsibilities of management in operating the enterprise, and of the investors and other users of financial statements for their various purposes."

It is a basic tenet of AFTF that current or potential shareholders and their representatives (analysts, portfolio managers, and management) need to be informed about value --- shareholder value --- the shareholder value of the business as a whole.  

AFTF supports the view that making predictions and reaching economic decisions are the responsibilities of management in operating the enterprise.  AFTF clearly separates these responsibilities from those of the modeler or the accountant.  See Chapters 11, 12, 13 and Appendix 3 of the draft proposal Accounting For The Future for details.

Kapnick was perceptively concerned about circularity if accounting starts to depend on capital market values since capital market values may in turn depend on accounting statements.  Right now this is not a great concern since capital market valuations are essentially independent of accounting valuations and accounting valuations are completely independent of market valuations.    This is a major failing of the current accounting model which would be addressed by AFTF, but which would bring the question of circularity to the fore. 

AFTF uses capital market values to scale accounting measurement.   It would seem that if capital market values are exaggerated(or understated) then so would financial statements be exaggerated(or understated).  The exact feedback mechanism is the historic cost of capital which takes its measure from capital market prices (see the Dual Validation in Chapter 6 of AFTF).   If capital market prices are higher then the historic cost of capital is lower.  Since the historic cost of capital is the discount rate for expected future cash flows, the present values, which constitute the company valuation, are higher.  Ignoring the fact that this is a highly desirable dependence, what can prevent it from going ballistic?  For one, the historic cost of capital is a five year average and fad-resistant.  Second, the historic cost of capital is an important and prominent part of the AFTF financial reports.  If it is unduly low or negative the markets will notice.  It represents the shareholder's yield.

What if management exaggerates expected cash flows causing capital market values to be exaggerated?  The historic cost of capital may appear normal (strictly speaking there is no feedback or circularity).  There are several disciplines that come into play.  First, management has little incentive to exaggerate expected cash flows since the company valuation, in the short run, will not be enhanced.  Second, in the longer term, the reported actual-to-expected cash flow ratios will manifest themselves.  Management will be held publicly accountable (a feature not present in GAAP accounting).  Third, the division of labor (management, modeler, accountant) will provide checks and balances.  The professionalism and integrity of those involved should prevent gross abuse.  The integrity of AFTF (its use for many functions) will enforce consistency.

The problem of goodwill cited by Kapnick is completely eliminated by AFTF.