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Some profound and thoughtful
observations for the next 100 years

By Robert J. Swieringa

We come to an age of technology, information, and global competition with a financial accounting model that was fashioned almost 100 years ago. In the early twentieth century, the balance sheet was the most important financial statement. Cost was viewed as a practical and satisfactory basis of valuation for assets held for use or sale, except that fixed assets were depreciated and inventories sometimes were written down to amounts that were below cost.

The historical cost, transaction-based model that emerged in the early 1900s generally has served us well over the years. But several areas are unclear and continue to present challenges.

Fair Value

The current accounting model is a mixed- attribute, transaction-based model. It is often described as based on historical costs; but the attributes are not limited to historical costs--current market values, net realizable values, and present values are used too.

That mixed-attribute model has worked reasonably well over the years. But some believe the mixed-attribute model should be replaced with a fair-value model. Fair value is the price that would be obtained under normal conditions between a willing buyer and a willing seller.

The Public Oversight Board of the SEC Practice Section of the AICPA urged the FASB to study comprehensively the possibility of fair value accounting. The GAO recommended the FASB consider the development of a market value rule for all financial instruments. However, a top-level government working group on financial markets that included former Treasury Secretary Lloyd Benston, Federal Reserve Chairman Alan Greenspan, and SEC Chairman Arthur Levitt, urged the FASB to go slow on market value rules for financial instruments, and the AICPA Special Reporting Committee recommended that the FASB not devote attention to value-based accounting at this time. The Association for Investment Management and Research (AIMR) has authorized a comprehensive study and report of the opinions of the entire AIMR membership on the role of market values in financial reporting.

Most recently, the GAO, in its report, The Accounting Profession's Major Issues: Progress and Concerns, stated its concerns about the mixed model and made a pitch for financial instruments at fair value and more forward-looking information about opportunities and risks.

The debate at the FASB has not been about changing to a different model. Rather, the debate has been about changing the mix of the attributes in the current model. The
debate has not been whether to use fair values, but
when to use fair values. The debate has focused on four questions.

Should Fair Value Be Used to Initially Measure Certain Assets? That debate has taken place in the context of contributions (FASB Statement No. 116, Accounting for Contributions Received and Contributions Made), mortgage servicing rights (FASB Statement No. 122, Accounting for
Mortgage Servicing Rights), and stock-based compensation (FASB Statement No. 123, Accounting for Stock-Based Compensation). Contributions and stock-based
compensation are required to be recognized at fair value, but mortgage servicing rights are required to be recognized at carryover basis.

Should Fair Value Be Used to Remeasure Certain Assets if Recorded Amounts Are Not Likely to Be Recovered? That debate has taken place in the context of loan impairment (FASB Statement No. 114, Accounting by Creditors for Impairment of a Loan) and asset impairment (FASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed of). An assumption inherent in an enterprise's statement of financial position prepared in accordance with GAAP is that recorded amounts for assets will be recovered. If that condition does not hold, recorded amounts generally are adjusted. But, should those amounts be adjusted to fair value? Impaired loans may be measured at fair value, but impaired long-lived assets are required to be measured at fair value.

Should Fair Value Be Used to Account for Certain Assets that Are Readily Marketable? That debate has taken place in the context of marketable debt securities (FASB Statements No. 115, Accounting for Certain Investments in Debt and Equity Securities, and No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations). During an extended period of reduced interest rates, financial institutions reported significant amounts of realized gains while concurrently having underwater investment portfolios. That behavior was described as gains trading, cherry picking, or snacking. Statement No. 115 retains amortized cost for some held-to-maturity debt securities, but Statement No. 124 requires that not-for-profit organizations account for all debt securities at fair value.

Should Fair Value Be Used to Account for Certain Assets When Underlying Rights Are Changed or Unbundled? Loans or receivables can be pooled or packaged into homogeneous portfolios and transferred to a trust or special-purpose entity that then issues debt or equity securities. Through the securitization process, receivables are changed or unbundled into new rights and obligations. Should those rights and obligations be recorded at fair value? FASB Statement No. 125, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, requires that some of those rights and obligations be recorded at fair value and that some be recorded at carryover basis.


Another unclear area under the traditional model is how to deal with uncertainties. Uncertainties about valuations are largely avoided by relying on amounts established in bargained exchange transactions. Yet, the results of transactions must be classified, and assets and liabilities represent future benefits or sacrifices. Some wish to minimize uncertainty by expensing all costs when incurred, unless there is clear evidence of future benefit, by requiring a rigorous association of costs and revenues, or by minimizing the use of estimates and allocations by sticking as close to cash accounting as possible.

Accounting tends to be viewed as objective and precise and as reflecting measures of past transactions and events. Yet, those measures are based on assumptions or estimates about future events. All balance-sheet accounts reflect estimates and assumptions.

Estimates are becoming more prevalent because contractual relationships are becoming more prevalent. Accounting for contracts is easy if they are simple, discrete, and of short duration; if they reflect limited relations between the parties; if precise measures exist for objects of exchange; if no future cooperation
is anticipated, and if no sharing
relations exist.

Accounting for contracts is difficult if contractual relationships are complex and of long duration, if they reflect close relations between the parties, if some objects of exchange cannot be measured currently, if some future cooperation is anticipated, if sharing relations exist, if some troubles are anticipated, and if interactions are assumed.

Complex contractual relationships exist for parent and subsidiary affiliations, financial instruments, contributions, postretirement benefit arrangements, compensation plans, insurance arrangements, warranty and service arrangements, regulated enterprises, software contracts, and so forth.

Accounting for objects of exchange that cannot be measured currently makes extraordinary demands on accountants as measurers. Consider postretirement health-care benefits--arrangements that may cover up to 80 years. Those benefits are in kind and indexed rather than fixed, the contracts are not as well defined as pension contracts are, and contracts are changing as arrangements evolve.

But, also consider reclamation costs that can cover up to 90 years, decommissioning costs, and the costs of significant extended warranties. All of those costs rely heavily on estimates of uncertain future events to make initial and subsequent measurements. Accountants are increasingly making interim measures of unfolding events. Estimates are difficult; changes in estimates are prevalent.

Consider the February 1996 FASB Exposure Draft--Accounting for Certain Liabilities for Closure or Removal Costs of Long-Lived Assets. Measuring those liabilities for long-lived assets such as nuclear power plants requires estimates of uncertain future events. The amounts and timing of expected future payments for closure or removal activities have to be projected over periods ranging from 40 to 60 years. The payments have to be discounted back to their present value at an assumed interest or discount rate to reflect the time value of money, and the discounted amounts have to be allocated between current and future accounting periods. Between now and then, laws and technologies may change. Actual payments may differ dramatically from expected amounts.

The expanded use of estimates in financial reporting is being driven by the increased reliance on contractual relationships and by the increased uncertainty associated with judgments, assumptions, and estimates.

A New World

The financial accounting model we bring to the new era was shaped by the existing corporate arrangements for large, complex, and more or less permanent business enterprises that invested heavily in tangible assets. That model will be challenged by more flexible and fluid organizational arrangements, increased investments in intangible or "soft" assets, more extensive use of financial instruments to manage various risks, and changes in information technology.

Alliances and Partnerships. There is an increased use of alliances and partnerships between telecommunications, entertainment, and information services companies; between pharmaceutical companies; between software companies; and between technology companies. The term "merger lite" has been used to describe arrangements in which talent and resources are combined, but each partner retains the right to link with others and retains its financial and other resources.

Where some alliances and partnerships reflect well-defined legal boundaries that are supported by contractual agreements, others reflect organizational arrangements that transcend legal boundaries by using the talent, resources, or governance structure of more than one entity. A "virtual entity" is formed to emphasize functional considerations. Highly specific assets are committed to the new arrangements, and those assets are integrated to develop and deliver products and services to the market, but the ownership of those assets is retained by the partner entities.

Alliances and partnerships essentially decouple decision rights from access to talent, resources, and sharing relations. Generally, the equity method is used to account for investments in alliances and partnerships, but those investments may represent only one of the many features of the arrangements.

Other companies are spinning off single-product or single-function companies. A technology company (Thermo Electron) that testified at the public hearing about the October 1995 FASB Exposure Draft, Consolidated Financial Statements: Policy and Procedures, has multiple public subsidiaries, each with joint ventures, licensing arrangements, and other links that form and dissolve in just months or even weeks. The company spins out certain of its businesses into separate subsidiaries that then sell a minority interest to outside investors. As a result of those sales and similar transactions, the company records gains in income that represent the company's increased net investment in its subsidiaries. Those gains have represented a substantial portion of the net income reported by the company in recent years. That company has brought the decoupling of decision rights and residual claims and the reporting of those gains to a new art form. Other companies are following the example of Thermo Electron.

Intangible or "Soft" Assets. Attention is shifting away from tangible assets to intangible assets. Companies that are building soft assets are now among the fastest growing segments of our economy. Service companies are investing significant amounts in employee and other training, technology companies are making significant investments in intellectual capital and research and development, and retailers and others are investing in internally-developed brands, customer loyalty, and satisfaction levels.

The SEC held a symposium on intangible assets in April 1996. The objective of the symposium was to identify specific financial reporting problems and to explore potential improvements to the financial reporting model.

The accounting issues about intangible assets are not new. In the late 1960s and early 1970s, there was a great deal of interest in recognizing investments in research and development and in human resources. A subfield called human resource accounting emerged and flourished. However, a watershed event was the issuance of FASB Statement No. 2, Accounting for Research and Development Costs, in 1974. That statement required that all research and development costs as defined be charged to expense when incurred.

In issuing Statement No. 2, the Board expressed concerns about the high degree of uncertainty about future benefits of individual research and development projects at the time the costs are incurred and the lack of a direct causal relationship between expenditures and benefits. The Board concluded that although future benefits from a particular research and development project could be foreseen, they generally could not be measured with a reasonable degree of certainty and therefore failed to satisfy the suggested measurability test for accounting recognition as an asset.

In March 1996, the FASB received a letter from the Software Publishers Association that requested that the Board reconsider FASB Statement No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed. The letter noted that where Statement No. 86 was based on an inventory model approach, sales of software have become more analogous to services or subscriptions than to inventoried goods.

The letter observed that the product cycle has shortened from several years in the mid-1980s to 18-24 months in the mid-1990s to less than 12 months today. Software development is increasingly funded by periodic maintenance fees, database software often is updated on a daily basis, and some online services charge on a number-of-images-used basis. Software companies find it increasingly difficult to meet the "technological feasibility" criteria of Statement No. 86.

The Software Publishers Association believes realization of software assets has become increasingly uncertain because of ever increasing volatility in the software marketplace, compressed product cycles, increased competition, and diverging technology platforms. It further believes that capitalized costs no longer are relevant to most users of financial statements and that the cost and effort to develop the information required by Statement No. 86 do not justify the benefit from recording an asset. Given the high degree of uncertainty in the product development cycle of most software, the association believes that software development costs should be classified as research and development expenses and charged to expense when incurred.

Financial Instruments. In the past 20 to 25 years there has been an increased use of financial instruments. We have experienced a sea change in finance. Fundamental changes in global financial markets have transformed the financial activities of all entities. Increased volatility in foreign exchange and interest rates and other market prices have greatly increased market, credit, and liquidity risks. Efforts to manage those financial risks, competition, and government deregulation in financial markets and services; structural changes in the economies and taxation of different countries; and technological advances in computers and information services have stimulated financial innovation.

The Board's decision to add the project on financial instruments and off-balance-sheet financing to its technical agenda in May 1986 was, in part, a response to that sea change in finance. That project was expected to develop broad standards for resolving accounting issues raised by financial instruments as well as those raised by the inconsistent accounting guidance and practice that had developed for those instruments over the years.

Where the FASB may have been somewhat ahead of the curve in 1986, it has fallen behind in the 1990s. After 10 years of effort, the Board has yet to come to grips with financial instruments. Instead of developing broad standards, the Board has issued a patchwork of inconsistent standards for marketable securities, loan impairment, and other issues. Those standards have been contentious because they have raised questions about the continued reliance on bargained exchanges and amortized cost.

The debate about financial instruments currently is focusing on derivatives. There is limited guidance about how to account for derivatives. The authoritative literature does not specifically cover many derivatives, so accounting for them is based on analogy to existing literature or on what has been done elsewhere in similar circumstances. Often the accounting depends on the intended use of the derivative and what is said to be the economics of the transaction. Derivatives are accounted for differently depending on whether they are intended to be used as a hedging instrument. Some derivatives that receive hedge accounting treatment may actually increase the enterprise's exposure to risk.

FASB Statement No. 119, Disclosure About Derivative Financial Instruments and Fair Value of Financial Instruments, improved disclosures of information about the way entities use derivatives. But, improved disclosures are not likely to be sufficient. The value of some derivatives can change many times faster and many times more than that of most traditional assets and liabilities.

The FASB has been at an impasse about how to account for derivatives and hedges. The hedge accounting model currently used for derivatives is the deferral method. That method, which dates back to the early 1900s and was developed for simple hedging arrangements, links changes in the values of the derivative to a balance or transaction with exposure to market risk and defers certain unrealized and realized gains and losses in the interest of "matching." The method is complex and its effects are not readily apparent to users of financial statements. The authoritative literature has limited the use of that method to specific circumstances. A fundamental issue is whether that method should be applied more generally. The FASB Exposure Draft on Accounting for Derivative and Similar Financial Instruments and for Hedging Activities was issued in June 1996. While proposing that all derivatives be measured at fair value, it maintains many of the concepts of the historic hedge accounting model.


The existing mixed-attribute, transaction-based financial reporting model has exhibited incredible staying power over the years. That model made the transition from farm to factory, and survived the challenges of the inflationary 1970s and the financial-institution crisis of the 1980s. It also is important to recognize that many of the challenges are at the margin and are not central to the model.

However, I believe financial reporting faces an important crossroads. A crossroads is defined as a place where two or more roads meet, as a place where different cultures meet, or as a crucial point or place.

Two very different paths are being advocated at this crucial point. One path is to delimit financial reporting. Some believe financial reporting has strayed too far from the reporting model that emerged in the early 1900s. Some believe more reliance should be placed on price aggregates that result from bargained exchanges and on matching revenues and expenses to measure income. Concerns have been expressed about the increased use of fair values, present values, and estimates in financial reporting.

Some are concerned that smaller entities are no longer preparing and issuing general-purpose financial statements based on generally accepted accounting principles. Some also are concerned about the costs of developing those financial statements and the extensive disclosures that are included.

Concerns also have been expressed about the usefulness and cost effectiveness of existing disclosures and about the increasing volume of disclosures in financial statements. Some have called for the elimination of less useful disclosures and for elimination of redundant requirements that result in essentially the same information being repeated in various sections of a financial report.

The other path is to expand financial reporting. Some believe too much reliance continues to be placed on bargained exchanges and on matching
revenues and expenses to measure income. Some believe that value
added by productive activity, discovery values, and gains and losses from
price changes and other changes should be recognized in financial statements.

Some believe financial reports should provide more information about plans, opportunities, risks, and uncertainties; should focus more on the factors that create longer-term value; and should better align information reported externally with the information reported internally.

I don't know which path will be taken. But the outcome of two recent initiatives may provide some indication about the future path of financial reporting.

The first initiative is the February 1996 FASB Invitation to Comment, Recommendations of the AICPA Special Committee on Financial Reporting and the Association for Investment Management and Research, that solicits views on the recommendations made in the December 1994 report of the AICPA Special Committee on Financial Reporting. That report recommended the development of a comprehensive model of business reporting that would include financial and nonfinancial data, management's analysis of those data, forward-looking information, information about management and shareholders, and background about the company.

The Invitation to Comment also solicits views on the recommendations expressed in the November 1993 position paper of the AIMR. That report describes financial analysis and discusses globalization of capital markets, accessibility of computing power, and the increase in economic activities that do not "fit" within the historic cost accounting model. That report discusses the qualitative characteristics of financial reporting and recommends improvements for financial reporting issues that the AIMR believes will be significant during the 1990s and beyond.

The second initiative is the June 1996 FASB Exposure Draft on Reporting Comprehensive Income. That proposal can be viewed as a relatively insignificant effort to tidy up the reporting of certain items that bypass the income statement and are reported directly in equity. But that view does not adequately reflect the potential of reporting comprehensive income.

Many people have strongly resisted attempts to include gains and losses from price and other changes in reported earnings. Reporting comprehensive income provides a way to recognize those gains and losses outside of earnings. Reported earnings can continue to be transaction-based and cost-based, and gains and losses from price and other changes can be recognized as a component of comprehensive income and reported in statements of income or financial performance. Reporting comprehensive income would--

* facilitate articulation of financial statements and would make nonowner changes in equity distinct and transparent.

* be consistent with the United Kingdom's "statement of total recognized gains and losses" that was introduced as a supplement to the "profit and loss account."

* be consistent with the comprehensive statement of activities that is required by FASB Statement No. 117, Financial Statements of Not-for-Profit Organizations.

* be consistent with a growing literature about accounting-based valuation and comprehensive income.

Discussions on these two initiatives will play an important role in determining the future path of financial reporting. All the items on the FASB's technical agenda will be completed or very near completion in a short period of time. Important decisions will be made in the months ahead. *

Robert J. Swieringa, PhD, a former member of the FASB, is now a professor in the practice of accounting at the Yale School of Management.

In Brief

At the Crossroads

The accounting model used today is one developed during the Industrial Age. It has served us well over the years, but several areas are unclear and continue to present challenges.

* The debate at the FASB has not been whether to use fair value, but when to use fair value.

* Estimates for uncertainties have become increasingly complex and difficult as exemplified by the accounting for postretirement health-care benefits and for obligations for certain closure or removal costs of long-lived assets such as nuclear power plants.

* The current accounting model will be challenged by more flexible and fluid organizational arrangements, increased investments in intangible or soft assets, more extensive use of financial instruments to manage various risks, and changes in information technology.

Former FASB member Robert Swierenga's observations clearly and thoughtfully present the challenges for the next generation of standard setting. As he states, we are indeed at the crossroads in financial reporting.

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