note: In May 1970 Harvey Kapnick was elected Chairman of Arthur
Andersen & Company, the firm he joined in Chicago in 1948. In
1956, at the age of 30, he became a partner and seven years later
he was made Managing Partner of the company's Cleveland office.
He has been a member of the Board of Directors since 1966.
Mr. Kapnick was born in Michigan. After serving
as an officer in the Army Air Force, he was graduated from Cleary
College in Ypsilanti, Michigan, and attended Graduate School of
Business Administration at the University of Michigan 1947-48. He
received an honorary degree, Doctor of Science in Business Administration,
from Cleary College in June of 1971. He and his wife and three sons
live in Winnetka, Illinois.
A Council Member at large of the American Institute
of Certified Public Accountants, Mr. Kapnick is also treasurer,
trustee, and director of numerous educational, cultural and philanthropic
[note: Fair Value Accounting -- this concept has
been given new emphasis with the Sandilands proposal in Britain.
The demands for international standards of accounting are increasing.
The concept of fair value accounting cuts across national boundaries,
philosophies and interests so that meaningful international standards
If the British go ahead with the Sandilands current
cost concept, and, if the United States goes ahead with price level
accounting, we will find ourselves in such chaos that international
standards are going to evolve whether we like it or not. The only
question is how.]
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 Accounting Lag
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?
A variety of reasons has contributed to the lack of progress. The
accounting profession may have failed to grasp the significance of
its role despite the increasing importance accorded to the financial
reporting of business enterprises. The standard -- setting function
is now on third base in the form of the Financial Accounting Standards
Board, after being on second base with the Accounting Principles Board
and on first base with the Committee on Accounting Procedure. Each
of these organizations has had different responsibility, authority,
and composition. Whether the team ever scores remains to be seen.
A factor contributing to the delay has been the accounting profession's
preoccupation with the need to narrow the range of equally acceptable
alternative accounting and reporting practices. 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.
Objectives Long Overdue
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 Committee on Accounting Procedure made a few half-hearted attempts
to consider objectives but never really accomplished anything in this
regard. The Accounting Principles Board commissioned two research
studies in this area. Several years later, the APB produced Statement
No. 4 on basic concepts and accounting principles that was nothing
but a meaningless attempt to rationalize from existing practices back
to concepts and principles, which cannot be done on any reasonable
basis. One potentially positive step was the publication in 1973 by
the AICPA of the Report of the Study Group on the Objectives of Financial
Statements. However, the Financial Accounting Standards Board since
its inception in 1973 has dealt with various subjects without any
established objectives. A public hearing was held on this subject
in September, 1974. A second public hearing will probably not be held
before September, 1976. This continuing delay is becoming increasingly
intolerable, resolution of this matter in the foreseeable future cannot
be predicted with much confidence.
Views of Our Firm on Objectives
In the absence of any authoritative set of objectives, each of us
must establish our own in determining what concepts and standards
would best serve the users of financial statements in today's environment.
Our firm has held the view for some time that the approach to corporate
financial accounting should be value based rather than cost based.
This was the position taken in 1972, as set forth in our book, Objectives
of Financial Statements for Business Enterprises. Advocated therein
was the viewpoint that the overall purpose of financial statements
is to communicate information concerning the nature and value of the
economic resources of a business enterprise, the interests of creditors
and the equity of owners in the economic resources, and the changes
in the nature and value of those resources from period to period.
Later in 1974, our firm published a book, Accounting Standards
for Business Enterprises Throughout the World, which expands further
our views with respect to objectives and sets forth a complete set
of illustrative financial statements, including notes, on the basis
of the objectives, concepts, and standards as we view them.
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. Exchangeability,
as the term is used, is not intended to suggest that an economic resource
is necessarily readily marketable or that it is being held for immediate
sale. Rather, exchangeability means that an economic resource is something
that is separable from a business as a whole and that has value in
and of itself -- that it is not solely dependent on the fortunes of
the particular business enterprise to which the resource is attached.
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."(1)
Value Basis Does Not Involve Valuing a Business Enterprise As a
An important distinction that is implicit in our approach to the
objectives of financial accounting concerns the difference between
valuing individual assets and valuing the business enterprise as a
whole. 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. The evaluations and interpretations
made by investors based in part on information provided by financial
statements should not be allowed to affect or to be introduced directly
into those financial statements. For example, the total market value
of a company's securities represents the market's valuation of the
enterprise at a particular time, but such valuation has no place in
the enterprise's financial statements. 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
Segregation of these functions requires that a careful distinction
be made between presenting financial information and predicting the
future. While financial statements should be presented in a manner
that will assist as much as possible in assessing the future and its
risks, the role of accounting and the resulting financial statements
is not to predict or to interpret the future. 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.
Man has always wanted to know about the future so that the uncertainties
of his existence can be overcome. Therefore, an interest in every
kind of financial information about the future is understandable,
since investors are more interested in the future, more concerned
about the uncertainty that may surround investments, than in past
performance. However, predicting the future is the very essence of
the investor function, and the investor who predicts correctly will
reap rewards, whereas the investor who predicts incorrectly may incur
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.
The problem is one of presenting the economic facts in the most useful
and understandable manner. This seems so obvious that it is difficult
to understand why the accounting profession continues to make excuses
Traditional Basis of Accounting Being Challenged Around the World
With inflation being a chronic problem throughout the world for the
last twenty years, and with the problems of obtaining and maintaining
capital in business enterprises, historical cost has come under increasing
challenge -- and for good reasons. In fact, the developments in the
United States have tended to lag behind those of many other countries.
The accounting profession in the United Kingdom has issued
a provisional statement suggesting the presentation of supplementary
price-level financial statements; however, that statement is likely
to be superseded by the recommendations of the government-sponsored
Sandilands Committee for a value approach for productive property,
inventories, and marketable securities. The profession in Canada
has issued an exposure draft dealing with supplemental price-level
financial statements and is working on value accounting, whereas Australia
has two exposure drafts under consideration -- one on price-level
accounting and one on replacement-cost. South Africa has published
a discussion paper on a value approach. Argentina has sponsored
price-level supplemental statements and is considering requiring this
basis for primary financial statements. For many years, Brazil
has had an indexing system for property and monetary items. Germany
is considering replacement-cost disclosures for items financed by
equity capital. Several companies in The Netherlands have used
a form of value accounting.
In the United States, the FASB in January, 1975 issued an exposure
draft requiring supplemental financial statements on a price-level
basis, with a comment period that ended in September, 1975. The FASB
has deferred action and apparently does not know what to do now.
The Securities and Exchange Commission has had a proposal out for
exposure with a comment period that ended January 31, 1976. This proposal
would require disclosure of the current replacement cost of most inventories
and depreciable, depletable, and amortizable assets used in the production
process at year-end and the approximate amount of cost of goods sold
and depreciation, depletion, and amortiza-tion that would have been
recorded on the basis of the current replacement cost of inventories
and productive capacity.
As a result of all of this and other similar developments, it is
becoming increasingly evident that these problems exist on a worldwide
basis and that attempts to solve the problems without common objectives
are makeshift at best and futile a worst. Whereas the United States
has had an opportunity to be a leader in objectives and basic concepts
on the international scene, it certainly has not done so. All we have
here in this regard is confusion and controversy.
Assumption of Stability of Monetary Unit Not Valid
Accounting has used the dollar as its unit of measurement under the
assumption that fluctuations in the dollar's purchasing power will
be so insignificant as not to undermine its usefulness for such purposes.
During certain periods, this assumption has squared substantially
with reality. In an inflationary period, however, it is difficult
to justify the continued reliance on this premise.
By the use of a general index of purchasing power, price-level accounting
adjusts the recorded amounts to restate them in dollars of equal size,
generally in terms of current dollars. Price-level accounting also
undertakes to measure, and reflect in the financial statements, the
gains and losses in purchasing power from holding monetary assets
and liabilities. Incidentally, this feature, although generally associated
with price-level accounting, can be used in connection with other
approaches to financial reporting. That is, computing the gains or
losses from holding monetary items can be done and the information
disclosed when the books are maintained on a historical-cost basis
or on some variant of current value.
Price-level accounting has deserved more support in the past than
it has received. There are no serious or mysterious implementation
problems because the procedures have been known for years and many
experimental applications have been successfully undertaken. In fact,
our firm included price-level adjusted statements as supplementary
information in its most recent annual report.
Price-level accounting results in comparative statements that are
comparable in terms of purchasing power. Even modest rates of inflation
erode the significance of comparative data. For instance, it is widely
understood that in recent years a sizeable share of the reported annual
sales growth may have been the result of inflation rather than of
gains in physical volume. Yet, such a condition is widely ignored
and conclusions are reached about sales growth by reliance on data
that are not comparable. On the other hand, restating each year all
of the prior financial statements shown on the basis of current purchasing
power has proven to be confusing to many readers.
A move to price-level adjusted financial statements would require
much educational effort to communicate the fact that a different kind
of measurement of success or failure has been adopted as well as some
different accounting techniques. The fact is that such financial statements
are not as easy to understand or as complete in reflecting economic
reality as value-based statements that include a maintenance of capital
We must recognize that price-level accounting, as it is generally
propose, would follow existing accounting principles and rely essentially
on the same old concepts. My previously expressed concern that accounting
has lagged and failed to accommodate sufficiently the many new developments
that have occurred in business will not be put to rest by price-level
accounting. Therefore, price-level accounting should not now be viewed
as necessarily a logical first step (as it might have been five to
ten years ago) that will initiate or lead to a change in the conceptual
structure of accounting -- the kind of fundamental change that is
needed so much.
A movement in favor of some form of replacement-cost accounting (sometimes
referred to as current-cost accounting) is obviously on the horizon.
Many of the present proposals for this approach are partial rather
than comprehensive. For example, the replacement-cost proposal of
the SEC would disclose isolated and supplemental data only for those
assets and associated expenses related to inventories, plant and equipment,
and natural resources. The position advocated by the Sandilands Report,
which would reflect current values in the primary financial statements,
has a similar weakness in that the financial reporting of some companies
and some industries would be unaffected by the kind of current-value
accounting being advocated. Because a financial institution is not
required to invest significant amounts in inventory and plant and
equipment, it may be exempt from the proposed accounting. However,
it does not follow that such an entity is unaffected by inflation.
Also, the proposal does not reflect the inflationary effect on other
items in companies that do have inventories and productive property.
Should those proposals advocating a partial system of replacement-cost
accounting be changed to reflect a more comprehensive approach, there
remains a weakness associated with any replacement-cost system of
accounting -- the reliance that is placed on a single value concept.
In some cases, replacement costs may increase while realizable values
or earning potentials decline for specific assets. How relevant is
replacement-cost information under such circumstances?
While the replacement-cost approach tends to provide for the maintenance
of productive capacity, because specific increases or decreases in
expenses that will likely be incurred when existing assets are replaced
are in effect anticipated, maintenance of productive capacity is usually
a far different goal than is the maintenance of equity capital.
Suppose that a change in technology occurs during an inflationary
period. Are earnings being realistically computed by applying lower
than historical-cost depreciation during inflationary times unless
some provision is made to preserve the general purchasing power of
the capital invested in the business? If depreciation charges are
reduced because replacement costs are lower, and as a consequence
greater earnings are reported and distributed as dividends, then conceivably
the resources retained within the business entity, though possibly
sufficient to replace existing assets, might not have the purchasing
power invested initially by the stockholders or committed when earnings
were retained in the business. This kind of accounting can lead to
A replacement-cost system that does not incorporate within its framework
some mechanism for capital maintenance is subject to serious question.
Some of the current proposals for piecemeal replacement-cost accounting
do not include such a general provision for capital maintenance.
Further, to require supplemental disclosure of certain replacement-cost
data in notes to financial statements may mislead investors rather
than provide useful information about the value of business assets.
Unfortunately, the replacement cost of an asset often does not represent
the "worth" or "value" of that asset. The realizable
value of a half-occupied office building may be far less than replacement
Disclosure of replacement costs for inventories may imply that sales
prices are based on such costs, which may or may not be the case.
Also, replacement costs for productive facilities may be considerably
higher in some cases whereas such new facilities may materially reduce
operating costs, and an incomplete portrayal of this could be misleading.
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.
Some interesting research was recently conducted by Professor James
E. Parker that illustrates my point.(2)
He obtained information from businesses owning a specific model of
a printing calculator about the depreciated cost shown in the accounts
when the asset was six years old. The amounts reported ranged from
zero to $280 for the same asset, all at the end of the sixth year.
Furthermore, there was no central pattern for the book values reported.
Professor Parker also visited a number of businesses dealing in office
equipment. He showed them the same six-year old printing calculator
and asked whether they would be interested in purchasing it outright,
not what it was worth as a trade-in. He received a number of bona
fide offers to purchase the six-year old asset. The bid prices ranged
from $40 to $120, but 60% ranged between $60 to $80. This range is
distinctly narrower than the zero to $280 reported following cost-based
accounting, where a range of $80 to $200 was required to include 60%
of the businesses visited.
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
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 account-ing? 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 account-ing 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.
1976 would be a great year for this kind of an accounting revolution!
(1) Paton W.
A., "Accounting Procedures and Private Enterprise", The
Journal of Accountancy, April 1948, p.288.
(2) *Parker James
E., "Testing Comparability and Objectivity of Exit Value Accounting",
The Accounting Review, July 1975, p. 512.
SELECTED QUESTIONS AND ANSWERS
In connection with value accounting, first as someone who has had
some experience over the past two score years in estate planning and
estate taxation, the problems of determining value are so grievous
that somehow or other in those contexts of value I can't help but
think of the punchline of that classic accounting anecdote where the
question is, "what number do you have in mind?" Second,
Mr. Kapnick, I'm going to refer to a play that you're intimately familiar
with, undoubtedly, Arthur Miller's play, The Price. What is the price
to be determined, value and use, value and exchange? But let me zero
in even more aggressively. Let me refer to three incidents that you're
intimately familiar with where value was certainly the standard. First,
when Berny Corrifeld wanted to skim $10 million out of the Investors
Overseas Services mess, he took $15 million, I believe the number
was, of land cost and zoomed it up to $115 million and skimmed off
$ 10 million, and when your firm was challenged, how did you permit
this to happen? The response in writing was "we're accountants,
we have nothing to do with appraisals, we cannot evaluate." Then
in another context, a grievous one, the Four Seasons Nursing Homes
situation, where it is true its percentage of completion accounting
which is a cost base approach but yet approaching value, to try to
factor in the value added as a result of the productive process. The
briefs that your firm wrote very persuasively and very effectively
pointed out the fact that we are accountants, we are not engineers
and appraisers, and the third, far more recent when we read the Price
Waterhouse commentary, as the special auditors in behalf of the courts
in a matter of Mattel, Inc., where the inventory of that toy manufacturing
outfit had to be brought down to value because of the obsolescence.
The accounting firm which was committed to a value standard even now
according to Price Waterhouse, fouled the nest grievously. The point
I'm making is related quite directly to three incidents that you are
familiar with and then to say now you tell us how you are going to
implement the value concept.
I would like to comment on each of those cases specifically because
they are important in the understanding of the value concept. I would
like to mention first, as you indicate, that there can be wide ranges
already in the cost basis, and that is one point that I tried to make
during my presentation. That is nothing different as to the existence
of ranges, whether you are on a cost basis or a value basis. Since
you refer to three cases, I would not want to go on without some comment
on each of the three. I think that the one thing that has been completely
misunderstood in the IOS case, and I believe you refer to this in
your book, is the fact that the Board of Directors was required to
value those assets. In a mutual fund there is no way that the Board
of Directors can avoid valuing those assets. Therefore, as to our
responsibility in that case, I want to make sure that everyone understood
that we were reporting on the basis of values determined by the Board
of Directors. If anyone were to refer to our certificate in that situation
you would find it quite clear. We indicated that these values were
based upon the opinion of the Board (not the opinion of our firm),
and that based upon such values the rest of the financial statements
were presented in conformity with generally accepted accounting principles.
I believe that this was a clear discharge of an auditors' responsibility
to point out that there was a very large asset on which we were not
giving an opinion as far as the valuation was concerned.
On the second case, the Four Seasons Nursing Homes situation, it
should be remembered that the court found two of our people innocent
and had a hung jury of ten to two for acquittal on the third person.
In the Four Seasons case, the accounting that was followed was never
successfully shown not to be responsible accounting. Some of those
who have talked a great deal about the Four Seasons case must remember
that to date no court has found the accounting to be lacking. We might
digress a moment to say in that case, as in other cases, the most
frightening thing to the individuals involved is the power of a Federal
government to bring criminal action against individuals with unfounded
allegations. The facts that I have discussed, both publicly and privately,
have supported the lack of credibility of the government's case.
As far as the Mattel case is concerned, that is still in litigation,
and I should not talk about that in detail. However, it must be pointed
out that where you have huge management fraud at the top officer level
it is very difficult for an auditor to detect, because the collusion
is such as to present an almost unauditable situation. Since that
case is in major litigation, Mr. Briloff, I would prefer not to make
any further comments on it.
Now, let's address the more fundamental issue. Do those three cases
destroy the idea that value is a proper concept for reporting to shareholders?
You refer to your experience in the estate planning. I am not naive
enough to believe that value accounting is easy. I do believe that
in this world in which we live the investor deserves better treatment
in the type and amount of information than he is now receiving. When
you see the complex footnotes that are constantly being proposed for
additional disclosure, it is almost impossible for anybody other than
the most sophisticated to understand the financial statements. If
that is where we are headed, we should take a good hard look at whether
or not the individual investor can determine for himself what is a
proper security for him to invest in. I would hope that with all the
techniques that are available today we could come to a value approxima-tion
that would be just as significant to the investor as the historical
cost basis, with respect to which he doesn't understand what the values
One other matter that is important is the role of the independent
auditor. I could encompass a lot in this if I really wanted to cover
everything, but the greatest disservice to the investor has been the
use of the short-form auditors' report. He reads that report and he
thinks everything is all right. You refer to the one qualified opinion
of our firm that addressed itself to the very issue that you criticize,
and yet how many investors look at the report and think if there is
a signature of a large firm, everything is all right? There is a company
in bankruptcy that was discussed in The Wall Street Journal this morning,
but I won't mention its name, in which a qualified opinion was given.
What is the role of the auditor in those situations? If he issues
a qualified opinion, is that adequate? Some people are apparently
beginning to believe, but I don't happen to believe, that the role
of the auditor should be expanded to such a point that he has a right
to determine whether or not a business survives. Our only responsibility
is to make sure that the facts are properly laid out. We may make
a mistake once in a while, and we have to pay for them because we
are human too. But the real role for the auditor is to qualify his
report, rather than to walk away from the audit. The auditor should
not have the power to bless or destroy. Rather, in my opinion, his
role is going to change that.
I think I got the feeling that you and your firm have proclaimed their
independence from the Financial Accounting Standards Board. What I'm
interested in is that recently Touche Ross came out with a program
designed for experimentation where they also went into a value accounting
approach. Now, to the best of my knowledge of the reports I've seen
from Arthur Andersen, there is that company in Indiana where you have
given an opinion on price-level-adjusted statements, but what is your
program, not for implementing the mechanics of value accounting but
for implementing its acceptance, its use?
There are several companies that are adopting, on an experimental
basis, price-level accounting based on general purchasing power. The
one you refer to is Indiana Telephone Corporation, which was headed
by a very fine man by the name of Pierre Goodrich, who for many years
felt that inflation would destroy America. He tried to show what the
inflationary impact was on private enterprise. What is our approach
to experimentation? I would like to see some real hardheaded dedication
to what is really needed. It does not take several years to adopt
a sensible approach to the objectives of financial statements. In
a recent article we indicated that one of the fallacies that appears
to be evolving at the FASB is that political pressures are wrong.
They say they are getting pressures from accounting firms, from Congress,
from industry, from academia, and from everywhere else. This is the
democratic process, and if you are going to have "due process,
" you must have the ability to withstand the pressures and make
the necessary judgement decisions. The Board members were selected
because of their integrity and all of the attributes that were needed
to withstand pressures. This is like what Harry Truman said, if you
can't stand the heat get out of the kitchen. We are at such a crucial
point today that we need action. We published statements on objectives
of financial statements in 1972 and 1974, and we would like to see
companies experiment with them. In certain countries we are doing
a great deal of work trying to help clients determine values.
In one situation we had the SEC agree that supplemental financial
statements on a value basis could be put in a report to shareholders.
Unfortunately, that client decided at the last minute that they did
not want to take the risk that went with that information at the particular
time. There is a lot of experimentation that could occur, but the
first thing that must happen is to reach agreement on concepts. Experimentation
isn't going to be worth anything unless concepts are established by
accountants and others who are going to make this decision. If the
accounting firms and the FASB can't get that decision made, then all
the experimentation that takes place is worth nothing, because we
need to have agreement on objectives first. There is no way that business
is going to accept a change in approach unless it is agreed upon as
a uniform basis by the body which we've all agreed sets accounting
principles. I have told Russell Palmer, and I congratulate Touche
Ross, that their booklet is excellent, and they have come out with
an excellent presentation. There may be a couple of other firms that
will support this concept, but why can't we seem to get it done and
I too support the concept, but I'm concerned and would like to comment
on some of the things you said were happening. Principally relating
to the revolutionary aspect of affecting the change. You mention that
it has been some forty years since the price-level accounting techniques
were first developed, and you express your disap-pointment at the
slow pace of evolutionary change. Yet, when the FASB finally came
out with their exposure draft on price-level accounting, much of the
responses that they received commented on the lack of understanding
and lack of familiarity with the proposal and the consternation that
would result from price-level-adjusted financial statements on the
part of an uneducated public. It strikes me that after 40 years we've
just reached a stage that to suggest revolution, when the techniques
for determining value as a sound concept may not have evolved at the
same pace or to the same extent, could result in a revolution that
produces more in the way of chaos than improvement. If we have a developed
price-level accounting technique, even if it doesn't do the same thing
and perhaps it isn't the first step to reflect the impact of inflation
on financial statements, perhaps it should be introduced on a supplementary
basis. The public would begin to get used to the concept of at least
accounting for the impact of inflation and might be better prepared
then to cope with the new concept of accounting for other factors
that cause change in value. We should allow a period of time to lapse
during which corporations, the profession, and perhaps government
could develop more specific types of tools that business and the profession
need to come up with current values that wouldn't be attacked as being
too conjectural and too subjective to have any usefulness. Could you
comment on some of those thoughts?
The basic issue that you are referring to, the issue of whether it
will be understood by the public, is whether there is a middle ground.
I tried to indicate this in my presentation. I think that a middle
ground was available in the 1950's and the 1960's and certainly in
the early 1970's, when price-level accounting was the way to address
the problem. However, we need to define the problem, because the facts
are being mixed up with a whole conglomeration of different concepts
throughout the world. You can have replacement accounting here; you
can have general price-level accounting here; you can have some historical
cost in one place and the current cost under the Sandilands report
in the U.K. Then I have to ask, what does financial information mean
on a worldwide basis? If we're going to really have meaningful data,
we have to have a common concept, the same as we have had a common
concept of historical cost. Except for the Netherlands, and except
for Brazil where there was major inflation, we have had essentially
a cost concept throughout the world until now. Now the issue is --
are we willing to have a fragmentation of that concept with all the
variations that are being introduced? I have concluded in my own evaluation
that we can get self-satisfied with all the footnotes and all the
supplemental statements that we could have, but the investors are
not going to understand them. They are not going to be able to have
a base on which to make the transition. Therefore, it seems to me
the leadership that's needed here is to develop a uniform value-based
concept throughout the world.
We should stop to think about the third world. The problem of the
next decade is transfer pricing that is evolving in the U.N., in the
OECD, and in other countries throughout the world. Transfer pricing
isn't a U.S. problem; it is not a U.K. problem; it is a world problem.
How are we going to solve transfer pricing problems? We finally have
to get back to whether or not we have answers today, and this leads
to some sort of value-based concepts. This gives us the solution or
the possibility of the solution to many problems. The real thrust
should be to reestablish the leadership of the United States profession
in getting to a value-based concept as quickly as possible. All changes
should be stopped, except what is absolutely needed, until we establish
a new direction and start moving toward it.
We were privileged about a month ago to have a speaker who managed
to describe financial accounting as a joint costing problem. In particular
I refer to Arthur Thomas. Yet today you came before us and said, I
can dismiss this notion of synergism between assets -- I can dismiss
this notion of the firm as a bundle of related assets. Could you go
a little bit further and elaborate perhaps a little on how you reached
the conclusion that I can view assets individually without their synergism
or joint effects?
I'm not sure I have your point, but you may be talking about my comment
that we do not look at the value approach as encompassing the valuation
of the entire enterprise. To determine value based upon earnings becomes
circulatory. The assets that are exchangeable and that have value
in and of themselves can be valued independently of the valuation
of the total enterprise. For example, some assets might continue to
be valued on a cost basis; other assets might be valued on discounted
cash flow; others might be based on appraisal values. We believe that
there is a whole variety of types of value concepts that could be
applied to provide meaningful data independent of the valuation of
the total enterprise.
Somehow I believe that with a value system, though it is very good,
shareholders would be quite confused by having a new type of financial
statements. We are now on a value base system and using the consumer
price index; we are not the same as last year and would have a problem
with consistency. Then again, you have to also consider some investors
do not have the sophistication to even understand what we do have
already in annual reports, 1OKs, I0 Qs, and in various other items
that we present to the public. This is illustrated by the number of
people who send away the little cards for the 10K that various companies
present. You also have to consider something else. For an unsophisticated
investor, what information does he really need in terms of value?
If we change around value, some companies are going to be very happy
about it and some companies won't. Those who won't be satisfied with
changing values will be those who have high fixed assets of various
kinds whose depreciation will change and their performance will look
worse than it did before. Or you'll have companies who look even better
now than they did before. If we are going to do something like this,
we should have a setup that is fair to the investors in terms of giving
them information that they can handle at a pace they can handle instead
of just throwing it at them all at once. An example is the treatment
of gains on the exchange of debt. First, we threw it into retained
earnings; then we took it out and put it on the income statement.
Now there is talk of bringing it back and putting it into retained
earnings again. The investor is looking at this and he sees high earnings,
and there it is below the bottom line. There are gains from exchange
of long-term debts of $14 million with total net profit of $16 million.
At least we've exposed it, but by constantly changing things back
and forth the benefits for either side really do not outweigh each
other. Someone is going to benefit more than the other, and it's not
going to be the unsophisticated investor. It is going to be the sophisticated
investor. It is going to be mostly the company that is doing extremely
well, and it will be those companies that have something to benefit.
Perhaps a jewelry concern who can play around with the value of various
stones. I have a client who would be happy to have something like
that. You have to be fair to all sides.
There is always a good way to have a debate, and that is to answer
a question with a question. You made a very sweeping statement. Some
companies are going to be better off and some companies are going
to be worse off. In relation to what? If I'm the investor, I'm paying
for economic value. Sometimes a stock gets up to 100 times earnings,
or 120 times earnings, where supposedly investors are trying to predict
the earnings stream. Are you better off with economic value or are
you better off with a matching concept? The first question is -- what
is the most reliable economic information that you can give an investor
who is reasonably intelligent? You say some of them might not understand
it. Then you get to the second point which obviously is the transitional
problem. I think that in a transitional period we probably should
have not only the statements on a value basis but also statements
on a historical-cost basis. To ask a man on the street whether a building
which is worth $500,000 should be put on the balance sheet at $500,000,
or whether it should be carried at its cost years ago, $100,000, you
will find out what he understands best. He doesn't need to be the
most sophisticated investor to understand value.
As I travel around the world I find that people do understand value.
They understand that cost which has no relation to today's economic
value is not meaningful. There are people who would say -- forget
about double entry if cost is to be the basis. Why do people make
balance sheets on scratches of paper when they are making acquisitions?
They don't talk about cost; they talk about value. Don't underestimate
the small investor. Give him the right information, which does not
take fifty pages of financial statements, notes and schedules with
all their complexities. Just give him 4 or 5 pages of real basic information.
I hope the question is sophisticated enough. I'm in accounting now,
and we basically work with historical cost. I just finished taking
an income tax course. Income tax is a big element in the business
field, and I'd like to know how value accounting would affect income
taxes. Would it take a whole restructuring of tax laws currently existing?
Well, not necessarily. I think that we may be evolving to where we
are going to have to have two or possibly three different types of
systems in order to properly control a business. We will need a management
control system, which may be somewhat different from the financial
reporting system to shareholders. I realize that taxes are a very
important part of the U.S. business climate, but taxation should not
control financial reporting. If we ever get to where the principles
of taxation control accounting, we get into a never, never land, because
the purpose of taxation is to provide revenues, not to present financial
position and results of operations. There is a possibility that if
some sort of value-oriented accounting is adopted, the impact of inflation
could become a tax deduction, I understand that this was a major consideration
behind the Sandilands report in the U.K. If some of you will talk
to your Congressmen and Senators, you will quickly find out that they
tell you -- don't come to the Congress on an inflation deduction unless
you are prepared to report it to your shareholders. They are not even
going to consider a deduction for inflation unless companies are willing
to report it to their shareholders. In Brazil, it is a deduction.
There is a tax deduction in Brazil for the fixed assets and working
capital, based upon indexes published by the government. These programs
can be worked into the taxation systems, but I would not hinge my
case on the adoption of value accounting for taxation.