Wake of the flood: the accounting scandals weren't all bad. Yes, they shook investor confidence. But they're also driving overdue changes in financial reporting.

Author:Millman, Gregory J.
Position:Finance
 
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It's all a matter of perspective. What some consider a catastrophic flood, others deem a cleansing bath. Witness the wave of bad news that began with stirrings of scandal at Enron and built over the past year into a crisis of confidence in corporate accounting.

Did we say bad news? On second thought, some experts suggest, maybe it wasn't so bad. "It seems to take a crisis to allow substantive and significant change," observes Ira Solomon, head of the accounting department at the University of Illinois at Urbana-Champaign. The crisis, he posits, may be just what the market needs to bring relevance to financial reporting.

Solomon and other critics believe the problem lies not in a few dishonest executives who gamed the accounting system, but rather in the system itself. Currently, corporations report too much useless information and too little that investors actually need, they argue.

"Accounting's function is to signal to potential suppliers of capital and labor the productive capacity of an organization, so that capital can flow to its most productive uses," Solomon says. "But the productive capacity of an organization is no longer revealed by its financial statements."

In fact, the fundamental economic case for a new approach to financial reporting has become so well accepted that it hardly admits debate. Put simply, value isn't where it used to be, and financial reporting standards fail to reflect that. A hundred years ago, factories and equipment were the keys to value. Andrew Carnegie's real wealth lay in his steel mills -- raw materials, plant and equipment and finished product. Today, intellectual capital represents the key to value. Bill Gates' real wealth rests in the heads of his software engineers.

Even manufacturing companies today see factories less as a key to wealth than a necessary evil. Often, they aim to minimize fixed-asset investments through such measures as strategic alliances, off-balance-sheet financing and outsourcing.

The body of generally accepted accounting principles, or GAAP, hasn't kept pace. There are more rules than ever, but all of them follow the same dated assumptions about what matters to a business. Testifying before Congress in February 2002, Federal Reserve Chairman Alan Greenspan found it necessary to warn about "the ever-increasing proportion of our GDP that represents conceptual, as distinct from physical, value." He stressed "the difficulty of valuing firms that deal primarily with concepts."

The Financial Accounting Standards Board implicitly confirmed Greenspan's observation in July, when it proposed...

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