Accountants thrive on precise numbers that seem tantamount to cold, hard facts. Mary E. Barth, one of the profession’s leading scholars, wants to set you straight.
Barth is not warning about fraud or even the legal forms of manipulation known as “earnings management,” though there’s plenty of all that. She is raising a more basic issue: that the accounting practices focus too much on the misleading certainty of “historical costs” rather than current values.
If a company invests $1 million on a new factory, for example, the standard practice is to initially record that factory at $1 million and depreciate it as it gets older. What’s wrong with that?
Plenty, says Barth, the Joan E. Horngren Professor of Accounting, Emerita, at Stanford GSB. The current value of a factory or any other asset, she says, has only a tenuous link to its original cost. The real issue is how much profit it can generate now and in the future.
“Would you rather know what a factory cost 20 years ago or what its value is today?” Barth asks. “The objective of financial reporting is to provide the best possible information to outside providers of capital. If you have to make a decision today, it seems intuitive to me that the best information is up-to-date information.”
Put another way, many of the numbers that we think are based on solid rock are actually based on shifting sand dunes. Indeed, says Barth, it’s almost an accident when historical-cost accounting practices actually correlate with a company’s underlying value. “That’s not a good way to run a profession.”
An award-winning scholar who also spent almost a decade on the International Accounting Standards Board, Barth says it’s time to give serious consideration to a very different approach: “fair value” accounting.
What Is Fair Value?
Fair value is an approach that takes into account an asset’s current value based on the price it would sell for in an orderly market transaction at that moment. That doesn’t mean there actually is a market or a buyer for that asset. But the value can be calculated from the income it generates and other factors.
At the moment, fair value accounting is used mainly for easily traded financial instruments, such as the stock or bonds that a company might hold. The idea is that it’s more accurate to value those securities at the current market prices – “marking to market,” in accounting lingo. If the value of a company’s securities has plunged by 50%, why not acknowledge that?
In a recent paper, Barth and Wayne R. Landsman at the University of North Carolina suggest that fair value accounting can provide investors with better information on many issues and that companies already do many of the calculations that underly it.
They also suggest that fair value accounting can be a good idea even when it comes to nonfinancial assets that aren’t actively traded and don’t have immediate potential buyers.
To do it, they say, a company could base the value of a plant or piece of equipment on the income it currently generates and the income it’s expected to generate in the years to come. If a plant generates either more or less income than expected in a given year, and there are reasons to think that the change will persist, the company would raise or lower the factory’s value to reflect that change in expected future earnings.
That’s how investors and potential buyers, who are putting their own money on the line, would calculate the value.
Responding to Naysayers
Critics of fair value accounting raise at least two big objections. The first is that it would put too much emphasis on temporary shocks — such as a recession — and distort the long-term picture.
Barth and Landsman say that doesn’t have to be the case, noting that many companies and investors already disaggregate the impact of onetime events from “core” or “recurring” earnings. In the paper, they outline several ways that companies can untangle “how various kinds of surprises in actual experience have changed expectations about the future and thus estimates of an asset’s current fair value.”
The other objection is that the fair value approach is based on estimates, rather than “hard facts,” and those estimates could easily be erroneous or intentionally manipulated.
Barth says that’s hardly a new issue. As concrete as historical costs may seem, she says, they too are based on all kinds of estimates that can be massaged in one direction or another.
“It’s not as objective or verifiable as you would think,” she says. “All of accounting requires judgments and relies on estimates from management. We estimate the impairment of property, plant, and equipment. We have depreciation. Banks estimate the impairments to their loan portfolios, and insurance companies estimate loss reserves. Almost every number in a financial statement is an estimate, but these are estimates we are all used to making.”
But couldn’t fair value accounting encourage companies to manipulate their earnings or even commit fraud?
“We already have a huge literature on ‘earnings management,’” Barth responds. “It’s not just earnings that get managed, either. If the leverage ratio is important, then they’ll manage the leverage ratio. If it’s the loan-loss reserve, they’ll manage that. Companies will manage anything. Anywhere there are opportunities and incentives, you’re going to get ‘earnings management.’”
Barth says she and Landsman aren’t expecting a sweeping shift in accounting practices. The real goal, she says, is to have professionals think more openly about the murkiness of current practices and the possibilities of a clearer approach.
“At least with fair value accounting, we know what the objective is,” she says. “We know what value is supposed to represent, so we have a benchmark against which we can assess whether we estimated it well or not. With historical cost numbers there’s no way to know how close we are because we don’t know what we’re trying to do. And, we do it differently for different assets. If the reported earnings actually provides useful information, it’s almost by accident.”