True and Fair Is not Hard and Fast

For accounts to reflect reality, they need to be more volatile and less precise. The procession of companies admitting to having lied in their reported accounts has undermined faith in corporate numbers and put the accounting profession under pressure to change its ways. In the 1990s, accountants clearly failed to keep up with the tricks that were devised to help companies inflate their profits. The first priority for those who set accounting rules has been to try to choke off the most obvious loopholes.

Looking further into the future, however, some see the crisis in accounting as an opportunity to change the shape and content of accounts more fundamentally. The growing use of market values for assets and liabilities (instead of the accidental "historic cost" at which they were obtained) is going to make shareholders' equity and profits swing around far more than in the past. Under such circumstances, profits may come to be stated as a range of figures, each of them arrived at by using different accounting assumptions.

This may sound worryingly uncertain, but it might be better than trying to rely on a brittle illusion of accounting exactitude, which is liable to collapse during times of economic strain. For the moment though, the efforts of regulators and standard-setters are focused on five main areas:

Pro-forma accounts. These are the first sets of results produced by companies in America: they are unaudited and do not follow America's GAAP (Generally Accepted Accounting Principles). In the years of the stock market bubble they were shamelessly abused. Companies regularly reported huge profits in their pro-forma earnings statements, only to register even larger losses in their official filings with the Securities and Exchange Commission (SEC). Since the end of March this year, companies have been compelled to show how they reconcile their pro-forma figures with the numbers subsequently produced according to GAAP rules, of which there are hundreds.

Off-balance-sheet vehicles.

These include the "special-purpose entities" made famous by Enron, which gave them the names of suitably fanciful characters in the Star Wars movies. They allowed the Houston oil trader to hide hundreds of millions of dollars of liabilities from investors' eyes.

The Financial Accounting Standards Board (FASB), America's privatesector standard-setter, issued guidance on these vehicles in January, which Ford and General Motors say will have a material impact on their profits this year. But some think that the new rules are weak because they allow exemptions for "qualifying'' special-purpose entities.

Stock options

 Most significant of all, perhaps, is the attempt to force companies to account for stock options granted to their employees. This week, FASB agreed that the cost of employee stock options should be treated as an expense. The question is, how to value them. The standard-setters may yet have a fight on their hands. In 1994, Congress threatened to take away FASB's standard-setting powers if it did not abandon its attempt to make companies "expense" their stock options. Opposition is gathering once more, although this time recent accounting scandals should lend support to FASB's position.

Pension funds. Another controversial aim is to make companies change the way they account for their employee pension schemes. Britain's new standard on pensions, FRS17, forces them to measure pension assets at market value. In future, if a company's pension fund owes its members more than it owns in assets, the difference will be shown on the balance sheet.

Outside Britain, such gaps can be smoothed out over years, with the result that some companies are still recording profits from their pension schemes despite the fact that the schemes themselves are in deficit. Britain's approach will spread; in March, FASB said it would start examining ways to improve accounting for employee pension plans, with the aim of publishing a new standard on pension accounting in America next year.

Revenue recognition. This is the vexed issue of when precisely to include revenue in the accounts – for example, when an order is made, when it is shipped, or when payment is received. Revenue recognition has been the main reason for restatements of accounts by American companies in recent years. Sir David Tweedie, chairman of the International Accounting Standards Board (lASB) in London, and his equivalents around the world want to lay down new rules on when a company can recognize revenue. Again, the effect could be far-reaching: companies could be made to look far smaller if they are prevented from pulling revenue forward from future periods, as many do now.

Future Standards

Standard-setters hope that today's mood of financial conservatism will allow them to tighten up other areas of accounting too. For example. Sir David wants all leases – contracts in which a company is committed to pay for the use of an asset over a long period of time – to be recorded on companies' balance sheets as debt. The result would be to make balance sheets larger and debt ratios higher.

Yet another goal is to shift the world's body of accounting standards away from rules (the approach favored in America) towards principles (more influential in Britain). The hard rules embedded in America's GAAP have helped devious financiers to design structures that obey the letter of the law but ignore the spirit.

But Bob Herz, the new chairman of FASB, is not optimistic about his ability to move GAAP towards principles and away from rules. Because companies and auditors demand certainty in America's litigious market place, the most he can do, he says, is to steer somewhere in between the two approaches.

Clamor for reform began in the 1990s. As share prices soared, people pointed to the growing gap between the book value of companies (what appeared in their accounts) and their market capitalization (valued on stock exchanges) as evidence of the irrelevance of accounts. The way to make them more relevant (and to stop executives from fiddling them) is, standard-setters believe, to force companies to value more of their assets and liabilities at market prices, to "mark them to market."

Instead of holding assets and liabilities at historic cost, and depreciating assets by a set amount each year, they maintain that companies should in future be required to mark them to market at the end of each reporting period. Big swings in values will then be passed quickly through the profit-and-loss account or through the shareholders' equity. Inevitably, profits will become far more volatile.

Derivative Issues

Using market value for all assets and liabilities will make some difference to how fixed assets are valued. But by far the largest impact of "fair value accounting," as the use of market value is called, will be to bring the volatility of financial markets into companies' results. Fair-value accounting, therefore, will affect banks and insurance companies far more than others, because they have the highest proportion of financial assets.

The slow march to market value is probably unstoppable in the long run, because so many accountants now believe that it is the most intellectually valid way to value assets. But nobody knows what will be the consequences of the volatility that would inevitably follow. In the worst case, large numbers of investors could be frightened away from equities.

In future, accounts are likely to become more volatile, more complex and more subjective. Overall, standard-setters admit that people who are not trained in how to read them will have to rely more than ever on experts.

But to help readers cope with the complexity of fair value, they intend to introduce a new way of showing companies' income instead of a single column with turnover and so on, the profit-and-loss statement will be presented in the form of a matrix, in three columns. One column will show gains and losses from changes in fair value, another would show old fashioned costs and revenues, and the last would show the total of the two.