ACCOUNTING a NATIONAL EMERGENCY Accmmting Must Move Into the Information Technology Era, by Roberi K

ACCOUNTING A NATIONAL EMERGENCY Accmmting must move into the information technology era, by Roberi K. Elliott and Poter D. Jacebson

he U.S. financial accounting model is im- m Getting closer to their customers. portant to the country's national competi- • Improving the quality of goods and ser- tiveness. The model, however, is broken vices supplied. and needs to be fixed. Its periodic, histor- • Providing a greater variety of product ical, cost-basis financial statements served offerings. the bygone industrial era well but are not • Cutting their product design and pro- sufficient for evaluating information-era duction cycle times. companies, Worse, they discourage com- • Downsizing and operating as truly panies from departing from the obsolete in- global enterprises. dustrial era while competitors (principally All products and services—and the Japan and Germany) are not being held means to produce them—are becoming back. Unless the model is brought into the more information-intensive. An automo- information era, U.S. industry will continue bile, for example, may contain a dozen or to be hampered by high capital costs, nasty more computers, and computers assisted in financial surprises in the marketplace and its design and construction. Training, re- deteriorating competitiveness. search and development, market studies, planning, design, advertising, internal com- MOVING ItfTO THE INFORMATION munications and other information activi- TICHNOLOOY ERA ties constitute an increasing proportion of Through the ages, mankind has developed the value delivered to customers. three fundamentally different methods of The industrial-era manager operated wealth creation; agriculture, industry and within a hierarchical entity, typically with information technology (see exhibit 1, page separate marketing, engineering, manufac- 57). As each new wealth-creation method turing, sales, accounting and finance func- supersedes the previous one. more sophis- tions. Hierarchical entities can grow very ticated accounting information is required. large, but tend to be slow moving because Information technology permits leading the separation of functions impedes fast ac- companies to become more competitive by tion. Industrial-era managers figure the "optimum" way to perform manufacturing ROBERT K. ELLIOTT, CPA. is a partner in the or processing tasks and build the entity's executive office ofKPMG Peat Manmck in New York. control system to "lock in" the optimum pro- He is a member of the American insHtnte of CPAs, duction process. In this system, there are the Neiv York State Society of CPAs avd the American Accounting Association.' PETER D. JACOBSON, standard productivity rates, and variations PhD, is senior editor in KPMG Peat Marwick's ex- are systematically suppressed. ecutive office in New York. Management's job in an information-era

5A JOURNAL OF ACCOUNTANCY, NOVEMBER 1991 company is much different. It attempts to need to manage. Some are experimenting organize as a network instead of a functional with systems that measure not only tradi- hierarchy. It no longer focuses primarily on tional financial attributes but also attri- a fixed basket of assets bequeathed by prior butes such as customer satisfaction, management (such as raw materials, fin- internal processes (productivity, quality ished goods and plant and equipment) and and cycle time) and capacity for innovation on the relatively fixed goals of production (learning curves and conversion of research and distribution. Instead, management to salable products). must focus increasingly on information as- A key difference is the financial measures sets (such as human resources, R&D, in- do not focus on earnings per share (EPS), formation systems, data on customers' return on assets (ROA) or return on equity needs and capacity for innovation) and on (ROE). Instead, they focus on shareholder the shifting goals of shorter product design value using concepts introduced by Alfred and production cycles, improved quality Rappaport in his book, Creating Share- and greater customer satisfaction. holder Value, published in 1986. These in- clude value growth duration, sales growth, U.S. ACCOUimNG MODiLi operating profit margin, income tax rate, FUNDAMEWTAUY INDUSTRm working capital investment, fixed capital in- Despite new managerial tasks, accountants vestment and cost of capital. Shareholder continue to supply the same industrial-era value can show results radically different financial statements—statements of re- from the earlier measures. A company can sources (balance sheet) and changes in re- have rising EPS, ROA and ROE and yet sources (income and cash flow statements). show declining shareholder value. Cost accounting models continue to rein- force the fixed-production-processes model. INJURIES FROM ACCOUKnNO The very account-coding structure followed MOPil PIFICIINCIES reinforces the hierarchy: The digits in a A number of constituencies have important general ledger account-coding structure interests in the accounting model, including represent the levels of the hierarchy—the investors, management and auditors. The left digits are high in the hierarchy (divi- identified deficiencies in the current model sional, for example), and the right digits are injure each of these constituencies in a spe- low (specific activities on the factory fioor). cific way. New accounting models are needed to Investors. Although too httle is known measure rates of change in resources and about the degree to which the current processes and to account for the off-balance- model actually serves the interests of inves- sheet assets so vital to the information-era tors, it is known investors obtain and rely enterprise. Management today would ben- on data from many sources other than the efit from continuous measures of business financial statements. Analysts meet with activity in place of summaries prepared management and follow what they can after the fact. Exhibit 2, page 58, compares about the company's research, the quality the features ofthe industrial-era accounting of its products and its cycle times. These model with those of a possible (but yet un- matters are treated as significant by the developed) information-era model. financial press. No one denies they are rel- Companies adapting to the information evant. Yet their absence from financial era are aware their accounting systems do statements means the statements cannot be not provide the types of information they fully relied on to judge stewardship. Inves- tors either go without such information or are forced to rely on presentations that may be oral, unaudited and impressionistic. Such presentations are not distributed as efficiently as financial statements. Management. The persistence of the in- dustrial-era financial reporting model in- creases the cost of capital. How? The risk- free rate of return—the Treasury bill rate—can be used as a starting point to pre- dict companies' cost of capital. To that rate are added premiums for economic risk and information risk—the risk that economic risk is misperceived because of incomplete.

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insufficiently relevant or insufficiently re- counting Standards Board has lost some of liable infonnation. The less certain the po- the constituency support it had when it was tential investor is about his or her founded, not necessarily in numbers of con- understanding of the economic risk, the stituents but clearly in their degree of en- higher the information-risk premium thusiasm. Moreover, the P^ASB has been charged. Conversely, the more certain the criticized for adopting requirements that potential investor is about understanding are unnecessary, too frequent and too de- the economic risk, the lower the informa- tailed and that fail to meet the test of pro- tion-risk premium. Today's periodic, his- viding benefits greater than costs. The torical, cost-basis financial statements do relevance of the required information, not provide as complete a set of relevant which can weigh so heavily on the benefits entity-specific data as is feasible to enable side ofthe equation, should be a more cen- potential investors to understand the eco- tral part of such debates. nomic risk of investing; this undermines the In the long-term, the FASB's support spirit of management's discharge of its fi- will depend on how it performs the second duciary responsibilities to shareholders. ofthe activities designed to achieve its mis- Although the full effect of industrial-era sion, namely, "tto] keep standards current public reporting on management is un- to refiect changes in methods of doing busi- known, there is reason to suspect it is not ness and changes in the economic environ- good. An intense focus on the information ment." As seen, there have been that might be usefully reported for an in- momentous changes since the current ac- formation-era enterprise should bring to counting model was developed. Responding light the types of data that can serve man- to the transformation from an industrial- to agement's decision making. an information-era business world could Auditors. An audit report is only as use- shift the dialogue about the FASB's per- ful as the audited information. If financial formance more toward what infonnation statements gi-ow less relevant, so do audits best serves users at this point in the econ- of those statements. Already there is grow- omy's evolution. ing evidence of price competition in the The U.S. economy. Ways in which the marketplace for audits. This could be a sign current accounting model keeps companies audits have begun to lose their role in di- from adapting to the information-era econ- minishing information risk because the au- omy have been noted. The model does not dited financial statements, even when provide information that could improve the credible and reliable, are less effective in efficiency of capital allocation, does not min- diminishing information risk. imize the information-risk factor in the cost Standard setters. The Financial Ac- of capital and can lead to faulty economic EXECUTIVE SUMMARY • THE CURRENT FINANCIAL ac- even auditors are harmed by the defi- counting model in the United States re- ciencies in the current accounting model. sults in financial statements insufficient Problems also are created for the FASB to evaluate information-era companies. and for the U.S. economy as a whole. • NEW TECHNOLOGY REQUIRES • THE FASB NEEDS TO TAKE a new types of business and investment leading role in studying investors' infor- decisions to be made, creating a need for mation needs and working to educate new types of accounting information. others about the information-era model. • BECAUSE MANAGEMENT'S JOB Management, investors and CPAs also in an information-era company is differ- can play an important part in pushing for ent, management must focus attention a new model. on information assets such as human re- • BECAUSE OF ITS INFLUENCE, sources and research and development. the SEC also can take steps to help the • NEW ACCOUNTING MODELS are United States adapt to the information- needed to measure rates of change in re- era model. sources and processes and account for • IN THE FUTURE, the language of off-balance-sheet assets, which are vital the information-era model can be used to to information-era enterprises. address current and coming problems as • INVESTORS, MANAGEMENT and well as business opportunities.

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decisions. Unrecognized human resource depending on less reliable sources for the assets, for example, can tempt manage- same information. The comparison to his- ment to take a short-term earnings lift by torical cost may make the new information dismissing or discouraging skilled person- seem soft, but the comparison to other, nel, which could be expensive when short- even softer, information investors are ages in skills and deficits in experience forced to rely on might make it seem rela- hamper future growth and profitability. tively hard. It would also throw light on Economist Lester Thurow has said the investors' needs—the FASB will be judged United States, where R&D is charged by its service to users of financial reports. straight to income, alone among major com- Management. Management should seek petitors has an R&D curve that rises and better performance measures for internal falls with the business cycle. This suggests use, as some entities are already doing. It R&D that can provide future economic ben- is clearly in their interests to have such efits should be capitalized, rather than au- measures for managerial purposes, and tomatically charged against earnings. they may in time contribute to general-pur- pose reporting. Management could take the WHAT SHOULD BE PONE? initiative by experimenting with voluntary FASB. The FASB should devote more re- disclosures that fit the information-era sources to studying investors' needs and ed- model. They would be helpful to the FASB ucating its constituencies about the as well as to investors, partly because they information-era model. This could be ac- would educate FASB constituents about complished in part by a study that also the new model. would test the argument that investors Such voluntary disclosures might not be need the kind of data the information-era an altogether off-putting prospect to man- model would provide. The study should ex- agement. The opportunity to recognize new amine the relationships among assets, such as human resource assets, for • Entity-specific information from gen- example, might be welcomed, demonstrat- eral-purpose financial statements. ing additional strengths to the investment • Entity-specific information investors community. actually apply in decision making. Auditors. It would be in auditors' best • Non-entity-specific information used in decision making (such as the course of the economy and ofthe industry, potential new EXHIBIT 1 competitors). Methods of wealth creation A parallel study should focus on the in- formation top management uses to make decisions, comparing it to what is made available through financial statements. The Three fundamentally different traditional distinctions between managerial methods of wealth creation. For and financial accounting should not mean each, a different form of accounting one cannot leam from the other. Whatever information is required. the differences between the two sets of in- formation, both should at least be based on compatible assumptions about the econom- ics of business enterprises. Moreover, top management may be using information dif- ferent from either set. Assuming these threshold studies sup- port pursuing the information-era model, the FASB should develop measurements to recognize operating factors that have pre- dictive value, such as human resource as- sets, cycle times, innovation, productivity and quality. In evaluating the trade-offs between the relevance and the reliability of information to be presented to users, the FASB should consider not only the relevance and reli- ability of the data that might newly be re- 8000 BC 1650 1955 Time quired but also whether investors are

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provide feedback on the relevance of the EXHIBIT 2 information provided under current stan- Accounting models dards. In this way they could make the kind of contribution only they can make, provid- Industrial era Information era ing hard data on investors' needs. Of course, investors and their represen- Measures resources. Meosures rates of chonge tatives may not see it in their interests to in resources. have information-era disclosures univer- sally available, because they sell and use Measures processes. Meosures rates of chonge their personally developed information on in processes. the value of securities. If that is true and Measures tongibles. Meosures intangibles. will be a fixedcondition , it must be accepted frankly, and investors' needs determined Focuses inwardly on Focuses outwardly on without their cooperation. production costs. customer values. Securities and Exchange Commission. Woits for events (transoctlons) Meosures processes in The SEC has the power to take the initia- to occur before measuring. real time. tive on adapting to the information-era model, and it also can influence the FASB Reinforces the hierarchy. Enables the netv/ork. to move in that direction. As a public-sector body, it has perhaps a greater obligation to establish a defensible basis for its actions interests to promote the information-era than even a quasi-public body like the model because they have so much at stake FASB. It would therefore be appropriate in the viability and usefulness of audited for the commission to research the need for presentations. Such efforts need not be re- adapting to the information-era model itself stricted or even primarily devoted to lob- or urge the FASB to do so. bying the FASB. Perhaps the best way There is a precedent for SEC research CPAs could promote the information-era on such issues: the Advisory Committee on model is by demonstrating they can report Corporate Disclosure, whose report was is- on the new disclosures and thereby provide sued in 1977. The committee was the SEC's investors with assurance of the reliability initiative: Its charge was very broad and its of the measures. report was well received and influential. In There is a precedent for this kind of work, addition, in serving investors through the as anyone who has followed the history of disclosure system, the SEC has taken steps forecasts and projections is well aware. in the past on grounds that the present ac- Once demeaned as too soft for presentation, counting model has limitations, for exam- forecasts are now routinely presented with ple, the requirement for management's CPAs' reports. Moreover, the precedent discussion and analysis. should help technically. The basic concept Finally, excessive legal liability exposure of evaluating the reasonableness of man- discourages management from reporting agement's assumptions may be the key to new information and auditors from attest- reporting on the disclosures that emerge ing to it. The SEC could work toward lia- from the information-era model. bility relief (for example, by establishing Investors, Investors can do more than be safe harbors), thus clearing the way for the the passive subjects of study. Over the new model's expanded disclosures. course of standard setting since the FASB began its work, investors have been in the THl lAMOUAOE OF BUSINESS ironic position of being both the featured Accounting has been called the language of constituency in the conceptual framework business, but there is good reason to doubt and the least active constituency in stan- that it alone merits that sobriquet today. dard setting's due process. That should end. In literature on modem management and Participating in standard setting's due- business, another language has taken its process procedures, with their discussion place beside accounting. It is the language memorandums, exposure drafts and hear- of the information-era model, used to ad- ings, can take a good deal of time. If that dress the current and coming problems and time commitment is the reason for inves- opportunities of business. The time has tors' lack of participation, selective inter- come for accounting to study that language, vention would be an alternative. Investors to select from it what elements can be ef- could focus their recommendations and fectively measured and reported and to de- comments on the FASB's agenda and also fine how to present it uniformly. •

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