by John Hughes
The CICA has issued a research paper Toward a Measurement Framework for Financial Reporting by Profit-Oriented Entities, written by the semi-legendary Alex Milburn, whom I’ve mentioned several times on this site in the past. They’re requesting comments on the paper by November 30, and have also established a blog where one can enter into discussion with the author. The object is to take a step toward “enabling a substantial improvement over the inconsistent and unintegrated mix of measurement theories and pragmatics that underlie existing accounting standards and practice” by proposing a more rigorous approach to the whole measurement process. I can’t hope to do justice here to the breadth and precision of Milburn’s thinking, but I wanted at least to bring the project to your attention.
He builds the paper on the following proposed definition of current market value: “The current market value of an asset or liability is its present exchange price determined, on the basis of publicly available information, by the competitive interaction of willing arm’s-length buyers and sellers in an open, active and orderly market.” For this definition to provide an appropriate basis of measuring any particular asset or liability, the current market value must be “practicable of faithful representation,” meaning that the value derived for a particular item “can be demonstrated to reasonably represent the essential properties of that measurement basis (within relevant materiality).” This emphasis on being able to obtain relevant observable market evidence distinguishes Milburn’s concept from the IFRS definition of “fair value”: for example, although the process of measuring an unquoted instrument by applying “Level 3” estimates requires considering the characteristics that market participants would take into account, there’s no requirement to obtain objective evidence about what market participants actually think.
In general terms, the framework proposes valuing all assets and liabilities with primary reference to the markets in which they’re acquired or issued or incurred, when the “practicable of faithful representation” criterion is met; otherwise, it proposes measuring them on the basis of the most relevant substitute that is practicable of faithful representation. This substitute might come from measures such as current replacement cost or deprival value, or might continue as now to be based primarily on historical cost if those other current measurement bases also aren’t practicable of faithful representation – either inherently, or because of cost constraints. Milburn’s paper doesn’t explore this area in detail – “accounting standard setters would have this responsibility.” It acknowledges that standard setters haven’t recently seriously considered these concepts, but urges them to do, noting that the practical ability to apply such measurements “may be expected to improve over time with future developments in markets and market pricing theory and with improved knowledge of and experience with estimation models and techniques.”
The income statement (or equivalent) would flow from these core concepts. Market value created by a cash-generating process (revenue) would be recognized when the process has generated and achieved an output with a current market value practicable of faithful representation. Changes in current market values of liabilities (or the substitute measurements applied) would also be immediately reported in income. The paper acknowledges that this continues a focus on assets and liabilities rather than on matching revenue and expenses, but reasons the two things aren’t opposing concepts when viewed within a sound model: “to obtain a valid matching, revenues and expenses must represent the results of sound measurements of increases and decreases in the economic values of operating assets and liabilities (i.e. matching is the outcome of properly identifying and measuring assets and liabilities, not an objective on its own).”
Milburn emphasizes that the principles proposed in the paper “would not necessarily result in more assets and liabilities being measured at current market values. This would depend on the judgment of standard setters and their constituencies on the practicability of their faithful representation.” As noted above though, experience and developments might allow an evolution in this area over time. I take it then (perhaps wrongly) that the object isn’t to prompt a financial reporting revolution, but rather to spark awareness that the mishmash of assumptions and models which underlies the current standards can’t possibly lead to anything except a more complicated and unsatisfying mishmash (IASB Chairman Hans Hoogervorst’s recent remarks about the multitude of measurement techniques and standard setters’ resulting struggles might be seen as implicitly begging for such an initiative). To analogize, introducing a new national constitution might not immediately change a country’s existing laws, but lays the groundwork over time to challenge and overturn them, to introduce a bill of rights, and in conjunction with changing community standards to normalize practices that might once have seemed unthinkable. Looked at in that kind of way, as the first shot in a long game, the paper seems to me invaluable, deserving serious consideration by the prevailing powers. At the same time it makes your heart sink a bit, because even if it received the most passionate and proactive reception imaginable (which of course it won’t in the current fatigued environment), it would surely take decades for its ideas to bear major fruit (embodied, say, by financial statements containing a greater use of current market values, with the complete acceptance of standard-setters and users, and with better capital allocation and other decisions flowing as a result). But what visionary hasn’t had to fight his or her way through layers of sinking hearts?
The opinions expressed are solely those of the author