Debits Don't Equal Credits

The present accounting model is over 500-years old and it is in bad shape. The traditional Generally Accepted Accounting Principles (GAAP) financial statements are based upon a liquidation value of a business, essentially historical cost assets less liabilities—a heroic attempt to assign static value to a dynamic concern.The balance sheet dates from 1868, while the income statement from before World War II. The P&L statement was set up to account for the most important cost in an industrial society: cost of goods sold. But in a knowledge economy, cost of goods sold—or cost of revenue—is less meaningful, with Microsoft averaging 14 percent of sales, Coca-Cola roughly 30 percent, and Revlon 34 percent.

GAAP: Irrelevant?

Even though intellectual capital is the main driver of wealth, you will look in vain to find it in the traditional GAAP statements—the balance sheet, income statement, and statement of cash flow. Increasingly, these statements are being referred to as the “three blind mice.”Enron and the other spate of accounting scandals from the early 2000s were not so much about fraud, malfeasance, misfeasance, or other crimes, but rather the increasing irrelevance of the traditional accounting reporting model. Enron’s legerdemain is not what caused it to fail. Its financial deception allowed it to remain in business for longer than an otherwise similar firm engaged in accurate financial disclosures, but this is a question of timing alone and not causality.The financial statements were simply lagging indicators of bad business decisions. Had Enron been reporting leading indicators, perhaps the market could have responded sooner.

As Talleyrand said about the shooting of the Duke d’Enghien, “C’est pire qu’un crime, c’est une erreur” (It’s worse than a crime, it’s a mistake).

Compounding the mistake was the passage of the Sarbanes-Oxley Act of 2002, which will not restore relevance to GAAP. All it does is pile burdensome and costly regulations onto a decrepit reporting model no longer relevant to an intellectual capital economy. This is the equivalent of Baron Munchausen’s struggle to extract himself from a swamp by pulling on his own hair.The accounting profession is a mature profession, and its last true innovation was the financial statement compilation and review standards, effective in 1978. This is a 28-year innovation curve, and counting. Additional governmental regulations will only slow this innovation down further (heavily regulated industries are rarely innovative; if the computer industry were as heavily regulated as auditors and accountants, we would have Vacuum Tube Valley, probably located in West Virginia).

It’s a Profit AND Loss Economy

Nearly everyone accepts the need for regulation. The debate, therefore, is not a dispute over whether we ought to have regulation, but rather about the best way of doing so.That being said, we need to keep in mind that in a free market economy, innovation and dynamism are the life-blood of wealth creation. Profits come from risk. Yet from Prometheus—who democratized fire by taking it from the gods and making it accessible to mankind—onward, societies have feared the innovation and the innovator.The recent securities fraud shareholder suits and the SEC fines imply the current demand is for risk-free investment opportunities. The current whine seems to be: “They didn’t tell me I could lose money!” We seem to want the profit without the loss (or to privatize the gains, and socialize the risks). This is simply an impossible objective.What we heard prior to the passage Sarbanes-Oxley was the “market failure” argument. Yet, what is never considered is when regulations are put into effect, they often substitute market failure with government failure. Enron, WorldCom, etc. all have gone bankrupt, and its leaders are facing criminal and other sanctions. Arthur Andersen is gone.The SEC, on the other hand, will get a bigger budget and even more regulatory authority, especially with the creation of PCAOB. The very agency that was established to “protect the investor” failed cataclysmically, and emerges with more power and authority. This is subsidizing failure, and we can be sure of one thing: it will happen again.One result of the Sarbanes-Oxley Act will be to increase the moral hazard of investing, because investors will now believe that new regulations have created a safer environment than is in fact the case. The result is they will take more risks than they otherwise would (similar to how deposit insurance increases passed by Congress led to the moral hazard of savings & loans engaging in riskier business dealings in the 1980s, since failure was subsidized by the government).

Accounting is not a Theory

Accountants and auditors focus their attention on the three traditional financial statements: the balance sheet, income statement, and statement of cash flows. These are all examples of lagging indicators, as they report on where a particular business has been. This may or may not be useful in determining where the business is heading. If users extrapolate financial reports into the future, they are relying on an implicit theory: the past will equal the future. A dubious notion.Real time financial statements would rise to the level of coincident indicators, since they would track present performance. But what every business should develop is a set of leading indicators that would enable it to get a sense of what direction the business is heading.The accounting profession proffers little help in achieving this objective for a very fundamental reason: Accounting is not a theory.Developing leading indicators requires evolving a set of falsifiable theories the business can test to determine the relationship between those indicators and future financial performance. The accounting profession has simply not taken the lead in this area. The reason for this may be explained by a joke told by a graduate economics student:

One day in microeconomics, the professor was writing up the typical “underlying assumptions” in preparation to explain a new model. I turned to my friend and asked, “What would Economics be without assumptions?” He thought for a moment, then replied, “Accounting.”

When Fra Luca Pacioli introduced double-entry bookkeeping in 1494, it was no doubt a revolution, which allowed businesses to expand beyond familial and geographical boundaries. Accounting to this day insists, quite rightly, that debits must always equal credits—that is, it is an identity statement, expressed in the following fundamental accounting equation taught in every beginning bookkeeping course:Assets – Liabilities = Owner’s EquityAn identity statement is true due to its definition. It is not a theory. A demand curve is an example of an identity statement—the summation of how much product customers would purchase at various prices. The supply curve is the same—a summation of how much product businesses would be willing to provide at various prices. It was not until economists combined these two identities into the scissors of the well-known supply and demand graph—inserting some assumptions along the way—that they posited the theory of supply and demand.The principles of accounting are also not a theory, rather they are simply a set of guidelines, rules, and procedures for measuring financial items such as assets, liabilities, revenues, and expenses, grounded by standards such as relevance, reliability, and materiality.One cannot use the accounting equation to predict a businesses’ future anymore than you can use the federal government’s budget deficit, or trade deficit, as a predictive tool. We may as well examine bird entrails. It is not the equation, or the measurement, that provides the usefulness, it is the context of the assumptions behind it that matter.Milton Friedman points out that he would rather live in a world where the government spent $1 trillion and ran a $500 million budget deficit than one where the government spent $2 trillion with a balanced budget, since the true cost of government is what it spends, not its budget deficit. Whether you agree with him or not is a value judgment, based upon how you view the usefulness of government spending. The numbers, in and of themselves, do not provide enough context to draw any insightful conclusions.Is it any wonder the accounting profession has not taken the lead in movements such as the Balanced Scorecard, which attempts to look at more indicators than merely historical financial performance metrics? Yet every executive team should develop a set of leading indicators—canaries in the coal mine—they can use in order to properly lead the business to profitability and excellence.Debits may equal credits to an accountant, but that offers little assistance—and even less insight— into operating a successful business. We need a new financial reporting model, one that provides interested users with leading indicators, which are far more useful in an intellectual capital economy than the lagging indicators we get from GAAP.It is time to reform the accounting model. Either the CPA profession takes the lead, or it will become increasingly irrelevant, relegated to part-time employees for the IRS, SEC, PCAOB and other governmental regulatory agencies. We are witnessing the beginning of the end of a once proud profession if our leaders—the Big 4, AICPA, grass root leaders, and academicians—don’t lead the charge to overhaul an increasingly antiquated accounting model.The place to start is to recognize when debits don’t equal credits.