Change accounting rules to match new ball game

“Rethinking the Rules of Financial Accounting”
By Robert N. Anthony
McGraw Hill, 2004


You walk down the streets of the country’s financial district, Ayala Avenue, and you would note impressive high rise buildings. The same is true when – immobilized by the intractable traffic re-routing within the Ortigas Center – you are awed by rows and rows of edifices challenging the heights.

And you wonder: Are the companies which own or have naming rights to these buildings really viable. But, you quickly remember an old adage not to “judge the book by its cover” (or a recent one from the sister of a lovelorn mayor: “Don’t judge him; he is not a book”).

So, speaking of buildings, don’t judge a company by its façade or its giant signboard. After all, there is always “a small company with a big sign” in every square meter of Ayala, Ortigas, Alabang and Filinvest business districts.

So, if facades won’t do it, how do you know the company you are talking to or investing in is well worth its image? Thank God, there are accountants who make sure you can see the innards of the company – with its balance sheet of assets, liabilities and equity. In the past, we could truly say we trust the financial statement as a sacrosanct document, its integrity beyond question. And, so we always said: “Look at the figures.”

And yet after the debacle of Enron (which initially impressed me when top Enron executives Ken Lay and Rebecca Mark flew into town by private jet some years ago) and after the wholesale accounting fraud by WorldCom, the sacred balance sheet has fallen out of grace. Not only that. With the advent of companies whose assets are not, strictly speaking, “physical,” how can one now reduce these assets to pesos and centavos?

Thus, you have “creative accounting” on one side where you need new investigative tools to spot any shenanigan, and you have hi-tech firms whose assets while purely intangible are inestimably valuable. This backdrop encouraged accounting guru Robert Anthony to write the book, “Rethinking the Rules of Financial Accounting.”

Anthony lays his premises well, drawing from the rigors of sciences. He points out: “Most disciplines – physics, chemistry, economics, medicine, engineering, and mathematics – have a conceptual framework for reporting measurements and a set of rules consistent with that framework. Those frameworks and rules have to be examined from time to time as the world changes. Inconsistencies in the rules creep in over time, and the rules do not incorporate new measurement techniques.”

This book is meant for accountants, with technical terms that may be abstruse to the layperson. But, if you are an executive, who went through Accounting for Non-Accountants or have gone through the rigors of MBA training, the fundamental issues raised by the book yield to some, if not easy, understanding.

Thus Anthony begins with a basic truth, “Accounting rules are rules for measurement” – and proceeds to define measurement as ‘the process of associating numbers with physical quantities and phenomena.’ Financial accounting rules measure ‘physical quantities’ in three categories – assets, liabilities and equity – at one moment in time.”

Arriving at a company’s net worth or true value is the crux of the problem confronted by the author. And yet, at the end of every chapter or section, he wrestles with the same old question: How do you reduce to numbers the operating performance of the company – and then how do you “photograph” its financial condition in a balance sheet?

The author begins with the first hurdle: terminology. He points out that even the Federal Accounting Advisory Board of the U.S. showed in a 1998 study that companies have two names for the same item. “Operating income” was used 356 times and “operating profit” was used 146 times.

He moves on to discuss the “Financial Position Statement.” After he volunteers a historical tidbit that the balance sheet has already been used for 500 years, he makes a shocking statement: The balance sheet “does not report an entity’s financial position.”

He explains: “The asset side does not, and cannot, report all the resources that an entity owns or controls.” He cites as examples the value of brands, new products, and the quality of a firm’s management. He also notes the increasing importance of these “intangibles” as knowledge-based assets.

An interesting “did-you-know” info tip is in this book. Accounting’s “dual aspect concept,” according to Anthony, was first used in Italy in the early 15th century by Luca Pacioli’s Summa (1494) who stated that accounting should measure two equal aspects of every transaction. He labeled one aspect “debit” and the other “credit”. It was widely used by companies sending a fleet of ships at the end of the voyage.

In more chapters covering statements on income and cash flow, Anthony argues for the use of the same terminology, no-nonsense recognition of income, and takes to task many creative financial maneuvers of companies which “window dress” their financial statements or are “dressing up the bride” prior to a sale.

He also draws similar and different problems confronting accounting rules for non-profit firms and government institutions.

From talking about rethinking the rules, the author also takes up ethical behavior among auditors and accountants. He says: “If professionals steal money, lie, produce an inferior product, or commit other sins, their conduct is illegal and they can be punished in the courts.” However, some conduct may be legal, but it can be unethical, he points out.

Doubtless, financial accounting is a serious matter. An executive can be thrown to jail for accounting fraud. Or, on the basis of an auditor’s report, a Chief Justice may be impeached. The author has a word for auditors: They must exercise “due diligence.” And that simply means: They must do enough work with the satisfaction that their financial statements report what they are supposed to report.

But, first of all, change the rules, because the 21st century corporate world is an entirely different ball game.