[Introductory
note: Homer Kripke (A.B. 1931, J.D. 1933, Univ. of Michigan) is
Chester Rohrlich Professor of Corporate Law, Finance and Taxation
and Director of the Securities Institute at New York University
School of Law. He was formerly Assistant Solicitor of the United
States Securities and Exchange Commission and Assistant General
Counsel of C.I.T. Financial Corporation. He has practiced law in
large and small law offices in New York, New Jersey, Illinois and
Ohio.
Professor Kripke is a member of the Permanent Editorial
Board of the Uniform Commercial Code. He was recently a member of
the SEC's Advisory Committee on Corporate Disclosure. He was a Consultant
to the American Law Institute's Federal Securities Code Project;
a member of the American Bar Association's Committee on Federal
Regulation of Securities, Professional Responsibility, Law and Accounting,
and Uniform Commercial Code, and the Committee on Securities Regulation
of the Association of the Bar of the City of New York. He was one
of the Reporters for the Review Committee on Article 9 of the Uniform
Commercial Code; a member of the Executive Committee of the National
Bankruptcy Conference; a member of the Council of the Section on
Corporation, Banking and Business Law of the American Bar Association;
a member of the American Bar Foundation's Advisory Committee on
the Corporate Debt Financing Project; a member of the Project Advisory
Committee for the Goodwill Project of the American Institute of
Certified Public Accountants; and a member of the Special Committee
on Lawyers' Role in Securities Transactions of the Bar of the City
of New York.
Professor Kripke has written widely in the field
of securities, legal-accounting problems, Uniform Commercial Code
and consumer credit. He is the author of a book on Consumer Credit,
of the SEC and Corporate Disclosure, and with Professor Fiflis,
of a book on Accounting for Business Lawyers (2d ed., 1977).]
My thesis tonight is going to be that the SEC's disclosure program
and its foundation, the current accounting model, need a bolder, more
penetrating theoretical structure, and my belief is that this can
best come, and will come if from anywhere, from the academic accountants.
The SEC's disclosure program has over forty-five years involved a
tremendous amount of effort, much boasting by the SEC as to what it
has accomplished, a vigorous enforcement program, a demand that everybody
-- lawyers and accountants, both inside and outside, and Boards of
Directors -- help the SEC in its enforcement program, and vast amounts
of commentary from outsiders both favorable and unfavorable. Yet despite
all of this there has been very little in the way of analysis as to
what disclosure is supposed to accomplish, and how it is supposed
to accomplish it.
Professor Alison G. Anderson, in the Hastings Law Journal of January,
1974, (1) pointed out
that there have always been two themes and purposes running through
the SEC's disclosure system. One is disclosure in order to prevent
gross frauds in the sale of securities, and not much more. The other
is the use of securities disclosure as an aid in making decisions
to buy, sell or hold securities. Although the original intention was
a little uncertain, unquestionably the SEC's rhetoric has tended more
and more toward claiming the value of disclosure for securities decisions.
The SEC undoubtedly had the right and power to steer it that way,
because the Congressional mandate prescribed a list of topics of disclosure
in a Schedule A to the Securities Act and left the SEC with very considerable
flexibility. Yet despite this turn in the direction of disclosure
for use in securities decisions, it seems to be literally, the fact
that the SEC for most of its history never asked the questions: "How
are securities decisions made? What factors enter into the decision
to buy, sell, or hold securities?" One would think that the SEC
would have tried to learn from persons who had the responsibility
for making that kind of decision what their decisional process was.
And yet the fact is, as an SEC top official said publicly in 1975.in
a program in which I participated, they had never made the inquiry.
For instance, they had never asked investors what their decisional
process was or what information they called for or how they used the
information that was available, and whether their thinking about the
relevance and materiality of information coincided with what the SEC's
thinking was as evidenced by the disclosures required in its forms.
In my view the pinnacle of SEC arrogance and solipsistic thinking
occurred in its Rule 146, adopted in about 1974, in which it prescribed
the disclosure required to be received by the prospective investors
in the case of private placements, even though it also required that
the persons permitted to buy securities privately without the benefit
of the SEC registration process should be people who were sophisticated,
able to "fend for themselves," or if not able to fend for
themselves, required to be aided by sophisticated offeree representatives.
Even though it limited the potential buyers and offerees to these
sophisticated persons, it nevertheless undertook itself to prescribe
what the disclosure to them had to be, rather than permit them to
decide what they wanted to know.
And yet the SEC's understanding of the decisional process was naive.
Its first effort to find out what users wanted to get out of the disclosure
process was the appointment early in 1976 of the Advisory Committee
on Corporate Disclosure, on which I served. On the verge of that appointment,
Ray Garrett, Jr. having just resigned as Chairman of the SEC and speaking
with the new program in mind, stated his view of what the SEC's understanding
of the disclosure process was; and I quote from Garrett's speech of
January 14, 1976:
"There is an implicit, fundamentalist Faith in the approach
contained [in the Securities' Act forms]. Investors make investment
decisions primarily by extrapolation from a company's past experience,
accurately portrayed. I certainly do not know and I am reasonably
confident that the Commission collectively does not know the extent
to which this is statistically true."
Phrasing that in my own terms, Ray Garrett said that the Commission
assumed that securities analysis consisted in an extrapolation of
past earnings records of the company into the future, and on the basis
of that, making estimates of securities values. He left unsaid the
obvious -- that earnings were based on the accounting model founded
on historical cost, and that the SEC was assuming that this accurately
modelled the past experience of the issuer. Well, everybody but the
SEC knew that that was not the securities decision process.
But the SEC, having assumed that the world resembled the accounting
model and that the securities decision process was based squarely
on it, depended almost entirely on accounting as the vehicle for corporate
disclosure. If you examine an SEC registration statement or other
disclosure document, there has been very little there apart from the
accounting. There is a description of the business, usually insufficient
for a person intending to make a serious study of the company. There
is a description of the management, what their experience has been
for five years, how old they are, and that sort of thing, insufficient
for anyone to make a realistic determination of the quality and depth
of management. Everyone knows that the only way you can find that
out is by inquiry among the peers of the company and not by disclosure
that you can realistically expect to come from the company itself.
Thus, realistically, disclosure depends upon accounting. But at the
commencement of the SEC disclosure process in the early 1930's, accounting
was like the earth at the Creation, as described in the first chapter
of Genesis, "without form and void, and darkness hovered over
the face of the waters." Under those circumstances the SEC's
most fundamental task, in my opinion, was to take accounting, the
only then available structure of information for securities decisions,
and help to shape it to be useful for investors. This, by the way,
is not a completely obvious proposition because we have only recently
reached a consensus, after the Trueblood Report, that the purpose
of financial accounting is to enable investors to make securities
decisions. The Institute of Chartered Accountants in England and Wales
had long insisted that that was not the purpose of accounting; and
many American accountants, including Mr, Murphy, the Chairman of General
Motors who had been its Controller, in a program that Sandy Burton
reported, continued to argue that the purpose of accounting was as
a report on stewardship to existing investors, and not to furnish
information for securities decisions.
At any rate, instead of taking leadership in developing accounting
for this purpose, as it did for the legal aspects of disclosure, the
SEC turned the matter over to the practicing accountants, with an
understanding dating from 1937, that is the basis of SEC Accounting
Release #4, that if the accountants would just get on with the job
of unifying accounting and deciding on accounting principles, the
SEC would let them take the lead. I have a great respect for the public
accounting profession, but if one segment of the financial community
was to get that job, it obviously should have been the users, not
the preparers or certifying accountants. But in 1937 our present professionalism
in securities selection did not exist, and only recently has its full
extent been recognized. The practicing accounting profession is handicapped
in the development of principles useful for securities decisions by
the fact that the SEC keeps them under constraints by the constant
threat of liability. There certainly are inglorious pages in the history
of the public accounting profession's performance of its duties under
the Securities Acts, and yet there is an area of inadvertent or negligent
failure to comply with accounting or auditing standards, that does
not deserve the kind of pressure that the SEC exerts.
A then standard accounting text, Gilman, Accounting Concepts of
Profit (1939), accepted as a fact that accounting represented
a series of expedient choices and that the result is net income, and
defended it on that basis. In 1940, in their famous book, Introduction
to Corporate Accounting Standards, Professors Paton and Littleton
sought to put a theory underneath the practice of accounting, namely,
that the accountant's process is to match costs and revenues. Some
critics do not take that as an acceptable formulation of a principle
and argue that matching is not a theory, but merely describes a process.
It doesn't make accounting mean anything more definable than
the result of the process as shaped by the realization rules.
But one thing that matching seemingly does is to provide an apparent
theoretical justification for another development which was occurring
during the same period, the fastening of the concept of historical
cost on the accounting process. If one goes back prior to the SEC
and into the 1920's, one can find that accounting was not based strictly
on historical cost, or on the concept of matching with paramount emphasis
on the income account. There were many examples of accounting, in
the early decades of this century, in which income appeared as the
difference between the net worths shown on successive balance sheets,
without a primacy of the income statement, and sometimes even without
the publication of such a statement. It was not at all clear how the
balance sheets were constructed. In many cases the net worth computation
depended on a valuation of the assets, rather than historical cost.
But when Paton and Littleton said that accounting is a process of
matching costs and revenues, the accountants seized on the word "costs"
and said "costs" mean historical costs, and therefore that
accounting is the process of matching historical costs to revenues.
But one can accept the concept of matching as a description of what
accountants do, without necessarily having to accept the theme that
"costs" mean "historical costs." If one studies
Professor Paton's writings, which range way back to 1920, and when
I studied under him in 1929, and way up almost into the 1970's, you
find a fluctuation in his concept of "costs" in the matching
process. Originally I think he meant value. Then in his book he asserted
firmly that costs meant historical costs. Later, after World War II,
when he saw the inflation, he redefined his process of matching and
said that costs meant current costs or values. It's easy enough to
make that change. The American Accounting Association once pointed
out that the process of matching can use "costs" to mean
opportunity costs, which are of course one attribute of value. Thus
the matching process need not nail accounting to historical cost.
But it served to do so. It was an expedient argument for doing so,
since there were other reasons for wanting to do so in the 1930's
and 1940's. The 1920's had been marked by alleged accounting abuses,
centering on values written up, and unfounded appraisals as the basis
of securities issues. I'm old enough to have read many securities
issue files of the 1920's in connection with the reorganization process
in the 1930's, when those messes were cleaned up. And then in the
1930s we had the converse: corporations were writing assets down below
historical cost, as a form of alleged conservatism but as a means
of getting rid of exhaustion charges and thus bolstering their income
accounts.
Thus we had several contributing factors -- the abuse of value accounting
both in the 1920's and the 1930's; the SEC's anxious desire for objectivity,
so its staff would have objective standards by which to examine the
filings; and the accountants' anxiety for objectivity so that they
too could turn their backs on abusive practices associated with valuations
and conform to firm standards and avoid the liability which has been
a potential of the securities enforcement process.
All of these circumstances served to carry accounting into the early
1970's with no unifying theory or vision and no penetrating search
for one in the practicing profession or the SEC. The AICPA's Committee
on Accounting Procedure published the ARB's and its Accounting Principles
Board (APB) published its Opinions, but they developed no theory:
they merely put out fires. The APB rejected proposals of Professors
Moonitz & Sprouse to move toward a theory based on value and away
from historical costs. The organization of the academic accountants,
the American Accounting Association, published statements of unified
theory in 1936 and 1966, and a number of committee reports moving
toward a value basis of accounting in 1964 and 1965, but the practicing
profession and the SEC paid little or no attention.
So where did we end up? One way to find the answer is to read closely
between the lines of APB Statement #4, which was the first official
formulation of the principles of accounting that received a large
measure of assent. It is written skillfully, and it seems to present
a logical picture; but actually, when one reads carefully between
the lines, what it says is, that sometimes accountants do this and
sometimes they do the opposite. The choices are motivated by expediency
and objectivity or other reasons, and when one gets done with this
heterogeneous process, the bottom line is called 'net income'. Net
income thus has no other meaning than the bottom line of this series
of expedient choices. We also ended up with a demand for something
better than APB and its products, and that led to the FASB, which
began functioning in 1973, vigorously supported by the SEC. To its
credit it should be said that the FASB has made a stab at the cost
or value issue, the central question of accounting and is working
diligently on a Conceptual Framework of accounting. Just by the tasks
it poses for itself, the FASB is a substantial step ahead. But let's
take a look at FASB's Conceptual Framework and its other positions
to date. Fundamentally, I think the FASB shows indication of being
very conservative and, above all, cautious. It has avoided taking
a position on cost against value and I doubt that many would believe
that the present period of experimenting with both forms of inflation
adjustment will lead to resolution very soon. Meanwhile, FAS No. 8
on Translation of Foreign Currency and No. 12 on Marketable Securities
contain indefensible provisions caused by inflexible adherence to
historical costs. There is no justification for this inflexibility,
since accounting has long permitted upward departures from original
cost in other cases of sure marketability as diverse precious metals
and packinghouse products.
Now I'd like to pick up an old controversy by going back to Harvey
Kapnick's lecture in this Series about three years ago, when he disapproved
the SEC's Accounting Series Release 190, which required replacement
cost disclosure, and promoted his own program for value accounting.
My very good friend Professor Abraham Briloff responded in a fury
and argued that approaches to value accounting were nothing but a
devise of the Establishment, the corporations, to obtain bigger depreciation
allowances for tax purposes and thus save taxes. Since the government
is going to need the same amount of money to run itself, in Briloff's
view this would mean that more of the cost of government would be
thrown on the individual taxpayers. Professor Briloff moved me greatly
with that argument, but the more one thinks about it, the more one
relaizes that his objection is not really fundamental. If we move
to value accounting and the bottom line of corporate financial reporting
and tax returns becomes very different from what it is, the result
must be that we will have a complete reconstitution of our income
tax structure. Political decisions -- not mathematical decisions,
but political decisions -- will be made as to the extent to which
different elements of the community bear the impact of taxes. I myself
would resist the attempt to use value accounting as an excuse for
shifting the overall burden of taxation, but I would not want a fair-minded
consideration of "the central question of accounting" to
be prejudiced by the fear of a capitalist coup.
It seems apparent that the FASB is not going to use its conceptual
framework for consideration of fundamentals. So far, the framework
is occupied with definitions and qualitative characteristics. Many
people have questioned, and I certainly question, whether FASB is
going to get anywhere struggling with the definitions and hoping that
principles will now from the definitions. There's a beautiful article
by Dopuch and Sunder in the Accounting Review of January, 1980,(2)
analyzing whether the FASB's statements on the objectives and elements
of accounting show any promise of enabling people to make selections
of accounting principles from all of this structural theory. And their
conclusion is that the definitional structure shows very little promise
of being helpful in reaching decisions. Beyond this, the conservative
approach is shown by recent decisions of the FASB. They have limited
their treatment of value to supplementary information, even though
they recognize that in this inflationary period, we must have some
approach to value accounting. They have refused to be venturesome
in recognizing a cost of equity, while producing in FAS 34 astonishing
complexities for mandatory interest during construction, frequently
with counter-intuitive results.
To summarize, it seems to me that the FASB is starting down a path
which may be largely sterile, and the SEC does not have the will to
force basic change. The only persons with a more realistic approach
to what the accounting process could be are the academic accountants.
As early as 1961, Professor David Solomons made a "guess"
that "the next twenty-five years may subsequently be seen to
have been the twilight of income measurement." The stubborn truth
that value is the present worth of expected future net cash flow
demands careful study of the entire structure of accrual accounting.
The FASB passes over the point, on the basis that accrual accounting
records events that have or will have cash flow consequences, and
is a better predictor of future cash flow than would be a straight
cash flow presentation. This formulation raises large questions as
to the function, in accrual accounting supposedly useful for securities
decisions, of depreciation charges and amortization of intangibles.
Dr. John C. Burton, when he was the SEC's accounting spokesman, said
that accrual accounting is an averaging process showing the cash generating
ability of the enterprise. But this formulation highlights the grievous
insufficiency of present day accrual accounting in the recognition
of the time value of money. In today's world when we have had 20%
interest rates, the time value of money is pretty important, as we
have all discovered. And yet these averaging processes deliberately
obscure the time periods in which cash consequences are going to occur.
Accounting was very late in recognizing the time value of money, and
perhaps the first occasion in which it consciously did so was APB
Opinion, #21 on the valuation of receivables and payables, only a
few years ago. Much of the gain in that opinion, I think, was largely
lost with FAS #15 on Troubled Debt Restructurings, which in effect
says that if you succeed in collecting your principal, even 50 years
from now, you haven't suffered a loss although you will have had no
earnings or little earning on your investment tied up during that
period.
It's hard to see that that gives any recognition to the time value
of money. Accounting still does not in actual practice give any effect
to time value considerations in the depreciation process. We have
straight line and accelerated depreciation methods. We have very few
depreciation methods in use on sinking fund or annuity methods which
recognize the time value of money. The interesting thing about it
all to me, as a lawyer, is that in another branch of accounting, in
management accounting, (capital budgeting) accounting does recognize
very firmly the time value of money and almost ignores the whole structure
of accrual accounting in trying to determine the potential profitability
of an investment opportunity by ignoring accrual thinking and looking
solely to the extent and timing of cash flows.
There is a need here for some fundamental thinking. It is not coming
and will not come from FASB, SEC, AICPA, the Financial Executives,
or their several constituencies. Their interlocking pressures for
conservative adherence to conventional thinking need not apply to
academic accountants, and I hope that the academics will turn to these
questions.
Academic accountants have already played a leading role in empirical
research on the use of accounting numbers in securities decisions,
and the effect of change in accounting methods on securities prices.
There is still need for a broader understanding of the securities
selection process. How does the analyst go from the SEC document to
the securities decision? You can find a great deal of discussion in
the Financial Analysts Journal and the Journal of Portfolio
Management, and elsewhere, about the analysis' analytic processes.
But you'd find it surprisingly difficult, as I did when I used to
run an interdisciplinary forum at New York University Law School,
to set up a program with some leading securities analysts to talk
about their processes of going from historical cost accounting statements
to the securities decision. I found no one willing to talk about his
process. I don't know whether they were afraid to show that the process
was ultimately intuitive, I think the process is a subtle one based
on an unarticulated process of considerable complexity.
That brings us to a question how far uniform, inflexible requirements
for disclosure by the SEC can contribute to this subtle process of
determining the worth of a security.
In the first place, the SEC disclosure process as a practical matter
can call for disclosure only about the company itself. It would be
unreasonable to require the company to make disclosure and projections
about the future of the economy as a whole, or even of its own industry,
because the company itself has no unique knowledge or ability to understand
the world better than anyone else. I don't suggest at all that the
company should make projections about the macroeconomic setting of
the company's future operations. Yet it is impossible to extrapolate
from the company's own history into the future without taking into
account the macroeconomic setting. Is there some connection between
the company and the macroeconomic setting that could be usefully put
into disclosure documents? The first thing we know is that every security
price is geared to market price performance. There are measurements;
of the history of that relationship for each security, known as the
beta coefficient, and there is a tremendous economic literature on
it in which the academic accountants have fully participated. There
are articles pointing out how the betas are affected by changes within
the company. It seems to me that some disclosure showing the gearing
of the particular security market price to an index of the general
market might usefully be made where the security has a public history,
with the beta defined as the market risk. This same economics has
found, in general, a linear relationship between this risk and expected
return on the security. The greater the beta or expected market risk,
the greater the return. One need not fully accept this mathematical
analysis to accept the fundamental insight that the return of every
security will be geared to the market. The economists specializing
in this study have been so busy playing with their numbers that they
have not approached the problem from the point of view of useful disclosure
for securities investors. The SEC's Advisory Committee on Corporate
Disclosure avoided the question, and we have yet to work through that
problem.
The next point is that it is now generally recognized that intelligent
security selection is done not on an individual basis but on a portfolio
basis, to achieve a diversification which minimizes the risk of the
individual security and picks related levels of market risk and expected
returns. The consequences of that have yet to be thought out in terms
of SEC disclosure. Moreover, portfolio needs differ among individual
investors because the existing status of their portfolios affects
their decisions as to what securities are attractive to them. Every
individual has portfolio needs based on a personal time horizon. A
security that might be attractive to a young executive, thirty years
old, with a comfortable income and an ability to look forty years
down the future, might not be attractive to me as I approach retirement.
On a cost/benefit basis, the potential increment of wealth or income
from risk-taking might be very different for some persons from that
of others, depending upon what their present respective status of
income and wealth is. The marginal utility values are different depending
upon what stage of the utility curve you are on. So, the possibility
of adapting security disclosure to the needs of the individual investor
has not begun to be explored by the SEC, certainly not by the high
pressure, mathematical economists.
The best article that I have seen in this field, and I do not claim
to have read all of the, vast outpouring of the literature, is one
by an academic accountant, Professor Hakanssohn of California, printed
in the Duke University Second Accounting Symposium of December
1976, which I commend to you as an analysis of what the problem of
securities disclosure for investment purposes really is. Hakanssohn
suggests that to analyze the security disclosure problem we need to
have a better model of the market, a better model of the individual
investor, a better model of the firm and a consideration of their
interaction of their interaction. It is a big order, but there is
a need to try for it. And the people most likely to command all of
the disciplines that enter into the effort are again the academic
accountants. The lawyers who have controlled disclosure all these
years cannot do it because the lawyers simply do not have the mathematical
or the economic equipment. The practicing accountants are not going
to do it. Sandy Burton's remarks in the New York Times a week
ago Sunday are very applicable. He asked, "Where are the angry
young accountants?" Paraphrasing that, one could ask, "Where
are practicing accountants who are looking beyond the need for doing
this week's job and filling the long term needs of the whole accounting
and disclosure process?" Despite their vast organizations, I
do not see it coming in the AICPA or the FASB, nor in the SEC which
relies on them.
The final question is a very big question, how far a mandated disclosure
process administered by the government, and necessarily rigid, can
serve the need of investors? Can we expect the government to find
a way not to treat all investors as uniform, to find some way to recognize
their respective time horizons and their individual needs or complementing
their existing portfolios? I have elsewhere applauded the recent proposals
of the SEC for changing the 10-K form, and related changes,
(3) but these do not deal with the fundamental
question I am raising.
Professor William H. Beaver, an academic accountant, as a member
of the SEC Advisory Committee on Corporate Disclosure, asked what
is perhaps the same question in the chapter which he wrote for that
Committee's Report. He first asserted (p.621)
"There is an implicit reliance on the functioning of the professional
investment community in order to qualify the current system as an
effective mechanism for disclosure. More-over, this community often
relies on investment information that is more comprehensive and
in some cases more timely than that contained in the mandated filings."
and then he asked:
"Under these conditions, the question arises concerning the
role of the SEC and its mandated disclosure system in the entire
framework. Why is it desirable to have a portion of that disclosure
system contain a mandated set of disclosures?"
It turns out to be the same question from different vantage points,
because each aspect presents the challenge whether the goals and the
potential accomplishments of our disclosure system provide sufficient
benefit to the public to warrant the mandated requirements. Above
all, we need to have a better knowledge of how accounting relates
to securities decisions and probably a substantially more daring accounting
model to model the business world more effectively. On both of these,
I have high hopes that the academic accounting profession can lead
the way.
(1) 25 Hastings
L. Rev. 311
(2) 55 Accounting
Review 1.
(3) American Bar
Ass'n. Section of Corporate, Banking and Business Law. Symposium on
Corporate Disclosure, Williamsburg. Va., March 15, 1980, forthcoming
in The Business Lawyer.
QUESTIONS AND ANSWERS
Question:
I am not very well versed in Accounting, so I may sound a little naive
at several points. However, investors as risk takers are constantly
concerned with the future and in the prediction of what will happen
to their money. All information is digested by the market and supposedly
is impounded in the market price, yet it's obvious that stock price
movements are not necessarily related to that information. Take for
example the recent jagged movement of oil stocks where there was no
way for anyone to justify the movement of those stocks upon strictly
analyzing financial statements. Do you feel that even if the numbers
are changed, it will really make a difference in how people are going
to invest their money -- whether they will be able to make more intelligent
decisions?
Dr. Mellman:
He is asking essentially if accounting numbers are improved by altering
the principles or the basis of accounting or improving the disclosures,
whether that will create a climate or improve decision making for
investment purposes?
Answer:
Certainly that is everyone's hope. While it is perfectly clear that
the matrix for investment decision is considerably broader than the
results or the future of the individual company, nevertheless the
company's past results and its future are an integral part of the
decision. If we have an accounting that comes closer to picturing
the company results and possibilities, we might very well have better
investment decisions. There is an interesting contrast between my
recent book and my general attitude, on the one hand, and that of
Martin Whitman on the other. Marty Whitman is an analyst in New York
who published a book just a few months before mine came out called
The Aggressive Passive Investor, in which his thesis is that
there are many aspects of value for a company that a sophisticated
investor can recognize but are simply not shown by modern accounting,
e.g., potential borrowing power, the use of the company's stock as
a means of acquisition if the company has a good price earnings ratio
and is not too heavily burdened with debt, and the like. Also, values
which are hidden by the deferred tax account showing as debt although
it will never become payable. Other types of distortions of what he
calls economic reality present in current accounting. Now to the extent
that accounting can be changed to bring out those potential values,
the opportunities in that field will not be limited to specialists
like Marty Whitman, but will be more freely available to other investors,
and price, presumably, will reflect it.
Question - Leopold Bernstein:
I am interested in your ideas about the efficiency of the market and
you said many investors obtain a free gift from the market judgment.
Of course, in the free market declines that we recently had, I am
sure you would be very happy to do without that gift. But if you have
such faith in workings of the market in terms of impounding all the
information, why do you not extend this faith to the marketplace for
accounting information? Accounting has evolved over many years with
the aid of the illustrious scholars that you have cited here. Bankers,
for example, have a very vital interest in financial statements and
what they present and they have created their own demands over the
many years. Isn't it possible that today's accounting statements are
pretty close to what the market wants? What is the force that prevents
the financial statements today from delivering what sophisticated
analysts on an equity basis or a loan basis really want?
Answer:
You remember, Leo, in my book, I faced that question and recognized
that there is very little support in many decision makers for the
ideas of switching accounting from historical cost toward any kind
of a value approach. I have to recognize that, and I conceded in the
book the potential force of your argument. But we have had this historical
cost accounting now since the early 1930's and there are very few
people old enough to remember that there was another time, and very
few people who can conceive operating under a different system. That
is particularly true of the decision makers in the insurance companies
whom George Benston questioned and whose votes on the subject I discussed
in my book. We have had no free market in accounting ideas because
the SEC and the Accounting Establishment have mandated the present
system, so we don't know what would be the outcome in a truly free
market, whether the present system would be accepted if rival systems
could have been offered and tried over the last many years and their
operations seen by others. We will get something like that beginning
this year as the supplemental information on value accounting comes
to be used. We will be seeing what its impact is on securities prices
and what the discussions are as to where reality is, the historical
cost result or the inflation accounting results. After we have had
some experience in that, I will buy your argument that the free market
will determine which is the better.
