Current values: finding a way forward.

• Author: Sutton, Michael H.
• Position: Includes related articles - Corporate Reporting

Historical cost is out and market value is in, some say. Not a chance, others say. Here's one suggestion on how to resolve the debate.

New initiatives in accounting are always controversial. The current debate over using current values to measure and report marketable securities in financial statements certainly is no exception.

Market-value proponents have no doubt that current value is the best way to determine comprehensive income and measure an investment's contribution to the owner's net worth. Opponents to market value are equally certain historical cost is best. This morning's investment value will inevitably change, they say, probably by this afternoon, and those changes in value, which are not realized, are irrelevant in measuring company performance.

We suggest a way forward. Our framework would retain the essential structure of the current accounting model, but would provide for greater recognition of market values in the financial statements. Financial assets that have ready markets would be carried at market value on the balance sheet. Unrealized changes in the values of these assets would be excluded from the traditional measurement of earnings. Rather, these changes in values, which are provisional until the asset is sold, would be captured and reported in a new, fourth financial statement that we call a "Statement of Changes in Provisional Values."

WHY THE DEBATE?

Today's complex economic and regulatory environments have tested the limits of the current accounting model. In addition to competition and escalating costs, companies cope with a broad array of financial market risks. For example, a sudden increase in interest rates can adversely affect a financial institution that has not matched the duration of its assets and liabilities. A stronger dollar can erode the profits of a multinational consumer products company when it has an important market share in another country. Exacerbating the risks of the financial markets is their volatility.

GAINS TRADING

Many regulators, including the SEC, are critical of certain practices that are rooted in the historical cost accounting model. One particularly troublesome practice is known as gains trading, in which the investor hopes to profit from changes in the direction of future interest rates. In its simplest form, the investor, believing that interest rates will decline, accumulates a portfolio of fixed-rate debt instruments. If interest rates decline as anticipated, the investor sells the securities. Under the historical-cost model, the resulting gains are realized and included in profits.

But if interest rates rise and the value of the investments declines, the investor most likely will elect to hold the securities as long-term investments. Traditionally, the ability and intent to hold debt securities to maturity have permitted the investor to carry those instruments at historical cost. Under the historical-cost accounting model, the investor has not realized a loss, even though the economic value of the investments has declined.

These outcomes are a consequence of the transaction-oriented, historical-cost accounting framework, under which gains and losses on investments are often reported only at the time they are sold. Critics point to the apparent contradiction of reporting profits in the income statement while the balance sheet may actually be...