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Mark to market: the U.K. experience.

There is considerable uneasiness in the United States among practitioners, policy makers and regulators about the quality of historical cost accounting--anxiety that has persisted for many years. A similar concern exists in the United Kingdom. This article's aim is to examine relevant U.K. research that may help the United States move closer to finding an acceptable and more relevant alternative to historical accounting.


The Financial Accounting Standards Board responded to concern about historical cost accounting with two standards prescribing fair value accounting--Statement no. 107, Disclosures about Fair Value of Financial Instruments, and Statement no. 115, Accounting for Certain Investments in Debt and Equity Securities.

The Securities and Exchange Commission also is a major player in the historical cost accounting debate. Its chief accountant, Walter Schuetze, believes historical cost accounting statements have outlived their usefulness and accounting standard setters need to provide an alternative definition of reportable assets that is compatible with both historical cost accounting and a variety of current value alternatives.

The American Institute of CPAs is another key player. Following a 1990 symposium on the appropriateness of historical cost accounting, it concluded there was a need to retain but reengineer the existing system by emphasizing value-based and forward-looking information. As a result of this symposium, the AICPA created a special committee on financial reporting. The results of the committee's work should be available this fall.


Faced with widely publicized financial scandals and criticisms of financial reporting similar to those heard in the United States, the research committee of the Institute of Chartered Accountants of Scotland (RCICAS) set out in 1987 to find an alternative to historical cost accounting. The findings should be of considerable interest to U.S. practitioners facing identical issues.

RCICAS began its work with a view of the future of financial reporting--very different from that expressed either by the SEC or the AICPA--that called for a revolution in reporting practice rather than a gradual evolution, saying

* There was no more room to fine-tune existing financial reports.

* Too much in terms of the profession's credibility was at stake to continue to support a historical cost system.

* There was an urgent need to start from scratch and provide a reporting alternative to meet users' needs.

RCICAS began a long-term research project to formulate such an alternative. In 1988, it reported its initial proposals for a financial reporting system in Making Corporate Reports Valuable (MCRV).


MCRV drew a number of conclusions and made several recommendations.

Financial statements. Existing financial statements are unsatisfactory. They are overly concerned with form over substance, the past rather than the future, cost rather than value and income rather than wealth. The balance sheet is an inconsistent hodgepodge of costs and values, and periodic income excludes certain relevant wealth changes such as unrealized gains. There is an obsession with the bottom line, and management discloses beyond what is required only when it has a self-interest to do so. Some reporting practices are incompatible with a normal understanding of financial affairs, and financial statements are almost incomprehensible to anyone other than their preparers.

Economic reality. Financial statements need to reflect economic reality and provide the type of information already required by management to make decisions. Principal user groups are investors, creditors, employees and business contacts. Users need reporting on

* Entity objectives.

* Wealth and wealth changes.

* Future status, performance and resources.

* The present and future business climate.

* Ownership, control and management.

Substance over form. To be more valuable, financial statements should be prepared to emphasize the economic substance of transactions rather than their legal form. It should be possible to add reported values to provide meaningful aggregations of accounting numbers and to reflect the current economic state of assets and liabilities.

The preferred valuation basis for assets should be net realizable value because such values are readily observable in the market and understandable to users, avoid arbitrary cost allocations, are easily comparable and help with performance assessments. Financial statements prepared on such a basis should include a statement of financial wealth, an operations statement describing changes in financial wealth as a result of trading operations, a statement of total changes in financial wealth, a distributions statement and a realized cash flow statement.

Other disclosures. These statements should be supported by other relevant disclosures--corporate objectives, segmented information, related parties and significant transactions, recent marketing or production innovations, market capitalization data, market and comparative operational data, three-year financial plans and three-year cash flow forecasts. An independent auditor should attest to the reasonableness of these disclosures annually.

RCICAS emphasized that the MCRV proposals were presented for purposes of discussion and acknowledged the need to resolve the problem of when it may not be in a reporting entity's best interests to disclose sensitive information. The benefits of the proposals were seen as protecting investors and creditors better, improving report users' judgments and enhancing the efficiency and fairness of securities markets. The 1988 RCICAS proposals represent total rather than partial mark-to-market reporting.


RCICAS recognized the MCRV report as only a first step and determined that other projects were necessary.

One project was a feasibility study known as Melody plc, in which a large public company's main subsidiary produced an annual financial report containing the statements and supporting disclosures prescribed in MCRV. These are some of the project's findings.

* Preparing the company's market-value-based accounting statements proved to be relatively easy. However, the statement preparation was influenced by senior management's longtime use of historical costs and its doubts about the relevance of market values and was constrained by the difficulty of obtaining market value data for special or unmarketable assets. The statement of cash flows was difficult to prepare because of the company's dependence on an accrual-based accounting system.

* Management was unwilling to report what it believed to be sensitive information concerning segment data, related-party transactions, innovation and the overall business climate. A one-year financial plan was prepared (the company could have reported on three years' expectations had time been available). An independent auditor's assessment was presented in which the financial statements were said to reasonably represent operations, distributions, cash flows, income and financial wealth.

The Melody plc study was broadened to apply the MCRV prescriptions to consolidated financial statements. A large public company cooperated in the project, known as Orchestra plc. Most of the study's findings were similar to those in Melody. The major difference was the strong opposition of Orchestra's management to using net realizable value to value the company's subsidiaries. Management favored using replacement cost, which it already had found feasible for internal reporting. Supplementary statements also were prepared using net realizable values despite management pressure.

To further evaluate the MCRV proposals, RCICAS commissioned other studies, including

* Application of MCRV prescriptions to the government-owned post office to demonstrate their feasibility in the public sector. The results were favorable; senior management found the resulting information particularly useful and continues to experiment with the MCRV proposals.

* In-depth interviews with senior executives of six companies of various sizes. The executives saw no major problems concerning the external reporting of corporate objectives and nonfinancial performance measures. However, they generally were reluctant to disclose budgetary data and environmental information on the grounds of jeopardizing competitive advantage. The interviews also revealed a strong impression that managers regarded financial reporting as an exercise in public relations.

* A project to investigate the extent to which corporate reporting currently included the MCRV disclosure recommendations. It found a small minority of large U.K. companies disclosed MCRV reporting suggestions voluntarily. The incidence of disclosure was highest when a takeover defense was needed.


Initial research demonstrated the proposed reporting system was broadly feasible and many existing reporting issues were potentially resolvable. In the second phase of the research, the goal is to discuss MCRV internationally; seek the views of preparers, users and auditors regarding the MCRV proposals; and consider fundamental conceptual and practical issues.

One final development regarding MCRV should be mentioned. An action group, comprising members of RCICAS and the research board of the Institute of Chartered Accountants in England and Wales, was formed in 1990 to accelerate the momentum MCRV generated. The group published an initial policy-making report for wide public discussion that voiced concern about the current state of financial reporting and recommended financial reporting change be driven by user needs. It suggested a reporting system similar to MCRV, with one major exception--the method used for valuing assets. The report recommended using a mix of current value methods appropriate to the assets being reported.


There is much consistency in thinking about the current state of financial reporting and the need for radical change. The current system on both sides of the Atlantic is perceived by a significant number of accountants as seriously flawed and to have a limited shelf life. The solution is a more relevant and reliable reporting package in which users' needs are paramount.

Although there may be differences in the detailed accounting techniques to be employed, the SEC and AICPA in the United States and the U.K. study groups favor disclosing current and future-based information and for financial statements to reflect the economic substance of transactions. The search for improvement is under way in the United Kingdom with the work of RCICAS and other bodies. It also continues in the United States, with FASB Statements nos. 107 and 115 and the work of the AICPA special committee on financial reporting.

Although the United States has made substantial progress, the work thus far has not addressed the crucial issue of the relevance of historical cost accounting to nonmonetary operating assets and is not based on the detailed developmental and feasibility work being undertaken in the United Kingdom. One hopes lessons from both efforts will be of mutual benefit in coping with what is a major crisis facing the profession.


* RESEARCH IN THE United Kingdom on replacements for historical cost accounting may help U.S. standard setters and regulators as they develop more relevant financial reporting policies.

* IN THE 1980s, THE RESEARCH committee of the Institute of Chartered Accountants of Scotland (RCICAS) undertook to find an alternative to historical cost accounting. It determined there was an urgent need to start from scratch and develop a financial reporting alternative to meet users' needs.

* RCICAS DETERMINED EXISTING financial statements were unsatisfactory. Financial statements need to reflect economic reality better and provide financial statement users with basically the same type of information required by management to make decisions.

* INITIAL RESEARCH BY RCICAS on its proposed reporting system demonstrated such a system was feasible and would resolve many issues. With the current financial reporting system on both sides of the Atlantic perceived as flawed, both the United Kingdom and the United States can learn from each other's efforts as they seek to cope with this crisis.
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Author:Lee, Tom
Publication:Journal of Accountancy
Date:Sep 1, 1994
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