William Feather

 

Definition of Accounting 

Accounting (traditional financial accounting) has been defined as, 

This definition is a wish-list not a reality. Traditional accounting is not a process, but a collection of processes. Traditional accounting does not identify major components of economic value and is incomplete. Traditional accounting does not appropriately measure the values it does identify. It fails to report shareholder value to the shareholder and lacks relevance. It is not oriented towards decision making. It does not properly inform and is not designed with its principal end-users in mind. 

These shortcomings are well known to the accounting profession, which has struggled to balance relevance against feasibility and objectivity. I believe that it is time for that balance to shift toward relevance; this book is designed to goad and encourage the accounting profession to make a shift. We live in a new environment with different needs and conditions. I believe that greater accounting relevance is needed. I believe that conditions are such that a new accounting model (AFTF) is feasible and that AFTF can be as objective and reliable as traditional accounting. 

 

The Problem of Multiplicity 

One obvious problem that accounting faces is the multiplicity of accounting systems. An accounting system should be an accounting system, not a hodgepodge of differing methods, measures, and results. There should be a single set of books. It is quite clear that current practices are not a single system. It is also clear that none of the traditional systems is suitable for general use across the gamut of applications. A single approach should be used for product development, pricing, for project evaluation, LOB analysis, company management, company financial statements, corporate reporting, and market evaluations. This requirement means that existing accounting systems must be scrapped. The tangled web of multiple accounting systems is confusing and evidences its own arbitrariness. A unified system would focus many disciplines and provide greater reliability. A single accounting system would tend to emphasize the great commonality of interest, rather than artificially forcing divergence. 

The differences between the various accounting systems are untenable. Even within financial reporting there are often contradictory systems, for example, life insurance company earnings are reported on a conservative statutory basis to the state regulators (with state variations, no less), on a slightly less conservative GAAP basis to shareholders, on a tax basis to the IRS. Within GAAP there are various principles in use. These principles are not always clear or consistent. The application of these principles changes over time, or from industry to industry, or from company to company. 

It is wasteful to employ multiple systems since attention is diluted and the costs are multiplied. Multiple systems are inefficient, but, even more to the point, they are, for the most part, ineffective. Multiple systems are not needed. Most users of accounting have similar needs for information. Uniformity can be achieved by abandoning the concept of earnings. If this is done, there will be no variations due to different earnings definitions. There will be no variations due to timing differences in recognizing earnings. In place of earnings, cash flows could be used directly. 

 

The Problem of Completeness 

One basic problem is that shareholder values reside exclusively in the future whereas financial accounting is essentially retrospective. There is no way for financial accounting to be complete unless it accounts for the future. There is rationale for periodic reporting, but less so for measuring and reporting effects for the current period only. Another problem is that traditional retrospective accounting measures only existing monetary quantities which may be a small fraction of a company’s value, especially in an increasingly service and information oriented world economy. For newer companies, the bulk of their value may be based on existing non-monetary assets. These may include: new technologies, products, processes, patents or other outgrowths of R&D; efficient and effective administrative capabilities; creative, skilled or highly trained personnel; a well developed consumer base; market dominance; superior marketing capability; a sense of purpose and vision; goodwill or customer satisfaction; agreements, options or other derivatives.

 

Only the future will realize these non-monetary values. Only an accounting system, which captures the future, will measure these non-monetary values. A complete accounting system must account for all value components, especially those that translate directly into future monetary quantities. 

Traditional financial reports are often adjusted and rearranged to be more revealing and to undo some of the damage done by accounting adjustments, such as, depreciation. One such presentation is the sources and uses statement, which outlines and balances cash generated and used for the period. A refinement of this is the cash flow statement, which subdivides cash flows into operational, investment, and financing cash flows

Traditional accounting makes use of the entity concept. The entity is defined as the company. The entity concept does not count the shareholder and is incomplete. A radically different picture emerges depending on the shareholder dividends. A company that retains earnings will, as time passes, report better results than a company paying out dividends. Yet the company retaining those earnings may not be covering its cost of capital. Things look better, but are worse. The problem is that traditional accounting does not have the shareholder’s view. The entity concept should be changed to include or be the shareholder. Traditional accounting does not recognize the cost of equity capital. The cost of debt capital is well defined and completely recognized. The cost of equity capital is not well defined by traditional accounting and is completely ignored. 

Traditional accounting is retrospective and doesn’t reveal whether a company is solvent or will remain so. Even a profitable company may encounter cash flow problems, often with permanent consequences. Traditional accounting generally assumes that the company will continue to operate as a separate entity. Rarely does a company assume liquidation, acquisition, or merger. If a company is not maximizing or is destroying shareholder value, it may be appropriate, from the shareholder’s standpoint, to know this and to know the financial consequences of, for example, the sale of the company. More important, management should be aware of the situation at the earliest time to forestall or correct problems.

 

 

The Problem of Relevance 

It is well recognized by end-users that financial reports do not furnish the information they require. Traditional balance sheets do not accurately portray the economic or market values that the end-user is interested in. Earnings statements do not correspond well with the economic progress or the change in market value of the company. The accounting profession is well aware of this lack of relevance of financial accounting, but has not yet felt pressured or motivated enough to change. In essence the accounting profession defines a convenient set of practices and procedures and transfers the burden of understanding and correcting their shortcomings to the user. There has been, as yet, no concerted attempt to satisfy the essential purpose of financial accounting, namely to provide shareholders with information of the type and scale that they require for their decisions. The reported net worth of the company must, at least, be of the same magnitude as the value that the market places on the company. The reported progress of the company must, at least, be in the same direction as the change in the economic value. Current financial accounting magnitudes and directions are wrong. Common sense dictates that this must be corrected. 

The cost concept of traditional accounting is fundamentally flawed. Under this approach the initial value of an asset is the cost of the asset. This cost is adjusted in later periods in a variety of ways, with little attempt to duplicate its value. Even the original cost seldom represents the asset’s initial value to the company. Generally an asset is purchased with the view that benefits will exceed costs, even taking the cost of capital into account. For example, the purchase of a computer may substitute for hiring an additional person; the value of the purchase decision may far exceed the computer’s cost. The cost concept can attach some number to the computer, but it cannot attach a value to the decision. If we value the decision process then we need to abandon the cost concept. The cost concept, by its fundamental nature, is not relevant to the management decision process or to reporting shareholder value. Assets need to be valued for their future net benefits. 

Another basic problem is that shareholder value is defined by the amount and timing of actual cash flows (dividends) to the shareholder. These are linked to the amount and timing of actual cash flows to the company. Earnings-based accounting time shifts those cash flows. Because money has a time value this shifting distorts values. An earnings-based accounting system cannot measure shareholder value and cannot be relevant for financial reporting to shareholders. 

The evolution and use of other types of accounting is evidence that financial accounting is not relevant to their essential purposes. 

  

The Problem of Matching 

Traditional financial reporting attempts to match revenues and costs. Since revenues and costs are generally not simultaneous, this matching is accomplished by shifting some revenue, or some cost, or some of both, to a different time. For the traditional accountant the timing of cash flows is a "mere technicality". Time shifting, without taking the time value of money into account, does violence to that value and makes traditional accounting matching unsound and unusable for most purposes. In addition, revenues and costs are generally not equal so that matching is subject to uncertain limitations. For example, if costs are known to exceed revenues, none of the excess is time shifted. 

With traditional financial accounting, revenues received or not yet received and costs paid or unpaid are time shifted to fit recognition or period matching judgments. It is necessary to judge whether a cost is an asset (delayed expense) or a current period expense. It is necessary to determine if there is a direct enough relationship between revenues and costs to suggest a certain matching treatment. It is necessary to judge whether an item of revenue or cost is material enough to require, permit, or prohibit a given financial accounting treatment. Immaterial amounts are often dropped through some crack in the traditional accounting model. These judgments create continual and substantial controversy within and outside the accounting profession. Any such judgments are arbitrary. 

Amortization of capital assets is designed to match costs with revenues, but substantial judgments are again required. First, it must be decided whether an expenditure is a current period expense or should be capitalized (delayed expense). Further, some asset life must be assumed, some depreciation method must be chosen, and some residual or salvage value must be assigned. Often real estate is fully depreciated over some assumed lifetime, e.g., 40 years, ignoring the fact that the property may have substantially appreciated during its "lifetime". Most accounting amortizations are crude, unresponsive, and incomplete. 

A delayed expense (capitalized asset) produces no yield for the simple reason that it doesn’t really exist as an asset. An anticipated expense (reserve liability) earns interest for the simple reason that it still exists as an asset. Pretending that expenses are paid at a different time only makes financial reporting artificial.

 

 The Problem of Rationality 

Some of the points raised above cast general doubt on the overall logical soundness of traditional financial accounting. How rational is it for there to be multiple accounting systems, or systems that are incomplete, or systems that are not relevant to the end-user? 

There is little consistency or rationale for matching so that it is necessary to know which special accounting treatment has been selected in order to understand financial reports. Such matching tends to distort and obfuscate. The boundaries of judgment, required in traditional accounting matching, create arbitrary discontinuities that defy logic. Traditional accounting is often an all-or-nothing judgement. Reality may be somewhere in between. 

Traditional accounting is often unbalanced or inconsistent. It is now required (see FAS 115) to value assets at market value, but a similar treatment is not permitted for liabilities. Overall consistency is lacking. There is a pervasive bias toward conservatism. This may be safe and prudent for the practicing accountant, but tends to obscure and may do more harm than good. It might be argued that conservatism and valuing only tangible (recoverable) assets, at least, protects creditors. However, creditors are best protected by a cushion of shareholder value, since the creditor has first call on assets. Protecting shareholder value automatically protects the creditor. 

Traditional accounting pays lip service to the concept of objectivity, yet judgments abound. When strict objectivity is inconvenient, the magic wand of immateriality makes things disappear. 

The use of period accounting is internally inconsistent. For example, the income associated with an expenditure is 100% if prior to December 31, and 0% if received one day later (unless it is classified as due and unpaid or the expenditure is capitalized). Accrual adjustments only take care of some of the mistiming. Traditional accounting revenue is sometimes recognized in advance, to the extent that it is "reasonably" certain to be realized within a "reasonable" timeframe. The amount of income that is reasonably certain takes into account income that is estimated will not be paid. This is an indirect way of arriving at an expected amount of some future income. Under traditional accounting both pre-collected and post-collected revenues are not recognized when collected. The difficulty arises in defining pre and post. The only objective timing is the time of collection. 

In a growing economy investment returns are easy to achieve. The greater the asset allocated, the greater the gains, often more in proportion. With a more mature economy, the incremental gains are often less in proportion to assets allocated. If the goal is maximizing the return on asset ratio (or the return on equity ratio) then less assets (or equity) may be desirable. The point is that increasing traditional assets (or equity) may or may not be desirable; traditional accounting does not make this clear. 

Extraordinary items are often so labeled so that they may qualify for extraordinary accounting treatment. Discontinued operations often result in reported losses, even though the decision to discontinue is financially advantageous. 

Many aspects of accounting are not intuitive or defy common sense. Why should positive outcomes be measured negatively? Why should shareholder reporting not be in shareholder terms? Why should accounting be a foreign language? Why don’t net worth or shareholder equity mean what they say? What are revenues, net revenues, gross income, income, net income, gains, earnings, profit, net gain? How does reducing assets (capitalized assets) produce an expense? Why are assets and surplus frowned upon?

  

The Problem of Inflation 

The existence of inflation is well known, but little is done in traditional accounting to recognize inflation. Net income may be up 3%, but this means little if inflation is 4%. Inflation is sometimes thought of as an increase in prices, but it is better thought of as a change in the purchasing power of the dollar, or, better yet, a change in the value of the dollar itself. The currency of today may be on a different scale from the currency of yesterday. To compare the two without adjustment is to ignore an important component of value. 

Holding assets at cost or at amortized cost soon deviates from the underlying pattern of value. Accounting for inventories, which have accumulated over time, creates a melange of costs from which difficult choices (LIFO, FIFO) must be made. Debtors and creditors profit or lose (to one another), from an economic standpoint, under inflation. This is not made clear with traditional accounting. 

High inflation can increase nominal future dollars and decrease their present value. The net effect of these two forces is unpredictable with current accounting; it depends on factors not currently accounted for.

  

Analytical Problems 

It is not surprising that the fundamental problems discussed above poison any attempt at analysis based on traditional accounting. A good example is the widely used Return On Equity (ROE). There are two main problems with the ROE ratio. One is with the numerator; the other is with the denominator. The numerator is the return only for the current period and so is incomplete. The denominator, on the other hand, is as of the end of the period and is associated with returns after the current period. Another problem is that traditional accounting equity (the denominator) is not related to the shareholder’s equity. Hence the ratio is of limited use to shareholders or their camp followers. 

A similar problem occurs with Price Earnings (P/E) ratios. These ratios are extremely variable because current earnings are not representative of valuations or future earnings. An expanding high-tech company may have negative or no current earnings and, yet, may have bright future prospects, but you would never know it based on traditional accounting earnings. The extreme variability of P/E ratios is evidence of the failure of earnings as a shareholder measure. 

Often the first step in analyzing the traditional accounting income statement is to identify and then undo many of the accounting adjustments that are made to cash flows. The balance sheet is more difficult to correct since it may represent an accumulation of accounting adjustments.

  

The Problem of Reliability 

FASB Concepts Statement No. 2: Qualitative Characteristics of Accounting Information, defines reliability as the quality of information that assures that information is,

    1. reasonably free from error,
    2. reasonably free from bias,
    3. and faithfully represents what it purports to represent." 

Financial reports are presented to the shareholders, so that the implication is that they are somehow relevant to the shareholder. This is also the inference drawn by the many readers of financial reports. Financial reports are what they are, but they are not what they in fact purport to be. Hence traditional accounting is unreliable 

Relative to their implied and inferred purpose, financial statements have large errors. For example, the accounting profession realizes, and may point out, that net worth or book values do not represent shareholder value, yet the fact is that even informed people regularly make use of these figures. There may be some consistency with traditional accounting, but this only means consistently large error. Traditional accounting is not representationally faithful since it does not "portray economic phenomena". It is difficult to even define a purpose for traditional accounting that makes it free from error. Hence traditional accounting is unreliable 

Traditional accounting is biased. It is biased in favor of conservatism. It is biased in favor of the past. It is biased against value. It is biased against the shareholders’ interests. Hence traditional accounting is unreliable.

  

The Heart of the Problem 

The above litany of problems points to more fundamental problems. There is a general failure of purpose and vision within accounting. This results from a general failure of traditional financial accounting theory. This heart of the profession is failing and the profession adds a Band-AidTM here and tightens a tourniquet there. For example, turmoil constantly surrounds the Financial Accounting Standards Board (FASB). There is rebellion and dissent from without and from within. Many FASB decisions are split decisions and they are frequently not well received by practitioners or theoreticians. FASB is trying to cope in a rational way with an accounting system that is fundamentally irrational, incomplete, inconsistent, unreliable, and irrelevant. FASB’s Band-AidsTM won’t cure the underlying problem. What is needed is a new accounting model that is not sick at heart. The accounting profession requires a fresh start.

 

Traditional retrospective accounting cripples all of its users. Shareholders, creditors, regulators, company management, and the accounting profession itself, are all handicapped, unnecessarily, by an accounting system of the past. It is possible to steer on the road to the future by looking out the back window, but is safer and faster to look out the front window --- and we can choose the destination. 

Conclusions

The problems with traditional accounting are well known, especially within the accounting profession. This recitation of problems does not represent an absolute criticism of accounting, the accounting profession, or accountants. However, we shall see that most of the above problems can be eliminated with AFTF so that traditional accounting, in these respects, is relatively inferior. The traditional accounting model is incomplete, not relevant, complex, inconsistent, non-intuitive, and out-of-date. We need a better accounting model in, of, and for the future. The AICPA, FASB, SEC, IASC, and others should consider the forgoing deficiencies in financial reporting and how they might be improved by AFTF.

 

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