The debate heats up
29 Jun 09
If further changes in accounting are proposed, there should be a thorough discussion about whether financial statements are the best vehicle for every purpose
by Paul Boyle
Accounting is integral to the structure of business in the UK and in many countries around the world.
It is directly related to the ability of business to organise itself by means of a limited liability organisation. Limited liability was one of the most important enablers of the industrial revolution because it encouraged entrepreneurs to take business risks on a scale that they were not previously prepared to. But there was a price for this privilege: limited liability companies were required to prepare and publish accounts (or, as they are now more commonly described, financial statements) and to have those financial statements audited.
These requirements have, with a few minor modifications, remained in place for 150 years and are now expressed in the Companies Act 2006. Over time, the emphasis has changed, however, and financial statements are relied on not just by a company’s creditors, but also by shareholders and a wide range of potentially interested parties. These users of financial statements have a potential large number of differing decisions, which they may have to take about the entity – for example, buy, hold or sell its shares, become an employee or cease to be one, extend credit to, or withdraw credit from it.
Although it would be possible to prepare different financial statements for each category of potential user which captured different aspects of a company or used different techniques to do so, the judgement has been made that it would be disproportionate to require companies to do so.
However, opting for a single set of multi-purpose financial statements has certain consequences. Firstly, the effort to satisfy the information needs of a wide range of users within a single accounting model will mean that almost all users will find that the statements contain some information which they do not find useful. Secondly, not all of the needs of all users can be provided by a single set of financial statements.
There are, of course, special categories of users of financial statements (for example, the tax authorities and the financial regulators) that have legal powers to require companies to provide them with precisely the information they require.
If, however, there is a wish to use accounting to achieve policy aims for which it is not designed, then this will have implications for the current uses of accounting. It is essential that there is a thorough and public debate about any such changes so that the advantages and disadvantages can be properly assessed and compared to the other options available for achieving those policy aims.
Turning to one particular debate, the current financial crisis has focused attention on the question of “mark-to-market” or “mark-to-model” approaches to the valuation of assets. Should investors be shown the market value of a company’s assets, even if that takes a snapshot of a market in extraordinary conditions, or even a market that is not fully functioning? Or should they be guided by the results of a valuation model approved by the board – effectively a “mark-to-management” approach?
Perhaps we should consider whether investors would find it useful to have disclosure of both market and model valuations. Given the uncertainty around the valuation bases, investors may also find it useful to compare information in future periods to help them assess which is the more reliable measurement basis. This could be done, for example, by requiring the disclosure in subsequent years of the difference between the proceeds for assets which have been sold and the market and model valuations at the previous year-end. There may also be other methods of conveying this information to investors.
Overall, I believe that accounting has held up well considering the extreme stresses in the financial system. I do not believe that there is any serious support for the proposition that accounting caused the financial crisis. Nor should there be support for the proposition that we can prevent a recurrence of the problems by changing accounting standards, any more than we can solve global warming by changing the scale on thermometers. n
PAUL BOYLE CA is chief executive of the Financial Reporting Council. The views expressed here are his own.