Citation
Samkin, G. (2010), "Early Warning and Quick Response: Accounting in the Twenty‐first Century:
Publisher
:Emerald Group Publishing Limited
Copyright © 2010, Emerald Group Publishing Limited
GAAP is unable to cope with the pace and complexity of modern economies. Both the accounting model and the standard‐setting process for developing and maintaining the model are broken beyond simple repair. They need to be stripped down and rebuilt for accounting in the twenty‐first century (Mosso, 2009, p. vii).
These are not provocative statements penned by a financial correspondent for a tabloid newspaper and designed to inflame the establishment, or made by an accounting academic closeted in an ivory tower and divorced from the reality of business. Rather these are the carefully considered thoughts of David Mosso in the first paragraph of his contribution to Emerald's Studies in the Development of Accounting Thought (Volume 12) (Mosso, 2009, p. vii). Mosso is able to make this claim from a position of strength as his credentials stand careful scrutiny. His previous positions include Vice Chairman of the Financial Accounting Standards Board (FASB), former Chairman of the Federal Accounting Standards Advisory Board and former Fiscal Assistant Secretary of the United States Treasury Department. This book of 86 pages (including references and index) comprises 14 short chapters.
The scene for the book is set in the first chapter. In accepting partial responsibility for the “shameful mess” accounting is in, Mosso uses the first chapter to identify inherent weaknesses with the current accounting model. These include, that accounting for economic activities should be a rigorous measurement process rather than its current pick‐and‐choose allocation process, accounting reports should provide early warning systems of impending financial crises, information should be comparable among reporting entities, and accounting standards should be capable of being applied with relative ease and confidence. Two new interrelated models for rescuing accounting are then introduced.
The three components of Pacioli's accounting model are introduced early in the piece as this forms the foundation of the proposed wealth measurement accounting model. These are: first, the model has a classification scheme with three basis classes, namely, assets, liabilities and owners' equity; second, two universal principles for recognising and measuring assets and liabilities – all assets and liabilities are recorded and all assets and liabilities should be measured initially at their cash values; third, a double entry bookkeeping system incorporating the classification and the two universal principles is used to construct a coherent model of an entity's economic component. A simple example is used to illustrate how the modern practice of permitting the value of an asset received in a barter transaction to be recorded at the book value of the asset given up, compromises one of Pacioli's universal principles, and contributes to the problems experienced with modern accounting practices.
A flaw in the current accounting model is predicated on there being no single dominant objective capable of assisting in making a decision about a particular accounting transaction. Mosso suggests it is this lack of a clear objective that is the cause of four fundamental problems identified with the current balance sheet. To overcome this, a new accounting model based on an expanded version of Pacioli's foundational concept of universal, no‐choice principles is proposed and considered in the first half of the book. Pacioli's recognition and measurement principles, together with the four additional principles proposed constitute the new wealth measurement model.
The advantage of the proposed wealth measurement model is that all balance sheet items are measured at fair value. Analysts would be able to look back on an entity's past transactions and events, and forward to trends and forecasts of future economic transactions and events. Comparisons between line items in different entities would be easy and reliable. Ratio analysis would be improved, meaning that a ratio such as return on equity would become a realistic economic measure that could be usefully used to compare an entity's return over a number of years, make comparison between entities or to compare against other types of investments.
A further advantage of the wealth measurement model is that it could be used to deal with the relationship between market capitalisation value and book fair value. A “Q” ratio is introduced where “Q” is the ratio between the market value of an asset and its replacement cost. A ratio of less than one means that the asset value is less than its replacement cost meaning new investment in similar assets is not profitable. If MC = the entity's market value and BV = the entity's replacement cost, the ratio MC to BV is comparable to “Q”. A ratio of less than one would indicate an underperforming entity. Under the wealth measurement model, MC – BV would resemble goodwill determined by passive shareholders providing a measure of market perceptions. Accounting for purchased goodwill would be revolutionised as it would not be recognised as an asset under the wealth measurement model's tighter asset definition. Purchased goodwill would be expensed immediately.
In the final chapter dealing with wealth measurement, sources of opposition to the wealth measurement model are identified. Additionally, the arguments that could be used to oppose the “all on” recognition, “all fair” measurement' and “volatility of earnings arguments” of the new accounting model are identified and countered.
The second half of the book deals with proposals to reform the accounting standard‐setting process. The reason Mosso believes the standard‐setting process requires reform is that its current form has two underlying problems. These are that the FASB (read International Accounting Standards Board (IASB), my words) and the current accounting model has no clear objective to guide choices. These underlying problems have led to four identified symptomatic problems; excessive due process, conflict of interest, narrow scope of most standard‐setting projects, and “buck‐passing”.
The wealth measurement early warning model is used to set the stage for an overhaul of the current standard‐setting process. As the form of the proposed model answers most recognition and measurement questions, a number of vexing issues currently under consideration would be resolved immediately. This would free up standard‐setting time for dealing with implementation issues. A quick response model of the standard‐setting process is then explicated.
Three chapters are allocated to dealing with the definitions of the elements of financial statements – assets and liabilities, the positive and negative components of wealth, and owners' equity in those assets and liabilities. Problems with the current asset and liability definitions are identified and alternative definitions are proposed.
A problem with having no current definition of equity (it is a residual) is that it is left open to classification errors when applying the current asset and liability definitions. This can lead to inaccurate measurement of wealth and financial health. The book provides a definition of equity in terms of the objects of wealth measurement, the nature of ownership and transactions that determine the amount of equity. The book distinguishes the differences between liabilities and equity under the wealth measurement model. Convincing arguments are provided for the classification of preferred stock, stock purchase warrants and stock compensation options as liabilities under the proposed model.
How the current accounting model results in the dilution of equity share value when shares are issued by an entity at less than fair value or purchased at more than fair value is considered. Mosso claims that this amounts to a wealth transfer by stealth, bypassing the earnings statement with real losses being transferred directly to owner's equity. An oversimplified number of transactions are provided to illustrate how transactions are accounted for under the current model and under the proposed wealth measurement model.
Two further claims made in the book are worth considering. Current difficulties in accounting for government and not‐for‐profit entities would be resolved if the proposed model was used and that the early warning system built into the wealth measurement model would have enabled the savings and loan debacle of the 1980s and the current financial crisis to have been spotted earlier, enabling corrective action to be taken.
The final chapter provides some dire predictions. If accounting standard‐setters and accountants are unable to get their house in order, the standard‐setting process will face government co‐option. Leadership from accounting academics as seekers of truth, and financial analysts, who seek truth as a means of accumulating and managing wealth, are called for as the wealth measurement model would serve their respective areas of interest and provide motivation for scrapping the current accounting model.
Is the author tilting at windmills? Perhaps! The project currently being undertaken jointly by the IASB and the FASB has recognised that problems exist with the current asset and liability definitions and have proposed amended definitions (www.iasb.org/Current+Projects/IASB+Projects/Conceptual+Framework/Conceptual+Framework.htm). However, at this stage a definition of equity has not been proposed. There currently seems to be little appetite on the part of the two major standard‐setting bodies to make rapid and wholesale changes to the current accounting model or the standard setting process.
The simplicity of the proposed model is appealing. However, the problem is not whether the model will function as proposed, but whether agreement can be obtained by all standard setting bodies. While I am currently not a convert, I do believe having a conversation about the wealth measurement model would be fruitful.
On a minor note I found the reference to Principle 2C in Chapter 3 (page 12) disconcerting as it was not something that had been addressed earlier. This book should be compulsory reading for anyone with concerns about the existing accounting model or the current accounting standard setting process. Additionally, it would make an excellent recommended text for an advanced accounting theory class.