ACCOUNTINGA NATIONALEMERGENCYAccmmting must move intothe information technology era,by Roberi K. Elliott and Poter D. Jacebson

he U.S. financial accounting model is im-portant to the country's national competi-tiveness. The model, however, is brokenand needs to be fixed. Its periodic, histor-ical, cost-basis financial statements servedthe bygone industrial era well but are notsufficient for evaluating information-eracompanies, Worse, they discourage com-panies from departing from the obsolete in-dustrial era while competitors (principallyJapan and Germany) are not being heldback. Unless the model is brought into theinformation era, U.S. industry will continueto be hampered by high capital costs, nastyfinancial surprises in the marketplace anddeteriorating competitiveness.

MOVING ItfTO THE INFORMATIONTICHNOLOOY ERAThrough the ages, mankind has developedthree fundamentally different methods ofwealth creation; agriculture, industry andinformation technology (see exhibit 1, page57). As each new wealth-creation methodsupersedes the previous one. more sophis-ticated accounting information is required.Information technology permits leadingcompanies to become more competitive by

ROBERT K. ELLIOTT, CPA. is a partner in theexecutive office ofKPMG Peat Manmck in New York.He is a member of the American insHtnte of CPAs,the Neiv York State Society of CPAs avd the AmericanAccounting Association.' PETER D. JACOBSON,PhD, is senior editor in KPMG Peat Marwick's ex-ecutive office in New York.

m Getting closer to their customers.• Improving the quality of goods and ser-

vices supplied.• Providing a greater variety of product

offerings.• Cutting their product design and pro-

duction cycle times.• Downsizing and operating as truly

global enterprises.All products and services—and the

means to produce them—are becomingmore information-intensive. An automo-bile, for example, may contain a dozen ormore computers, and computers assisted inits design and construction. Training, re-search and development, market studies,planning, design, advertising, internal com-munications and other information activi-ties constitute an increasing proportion ofthe value delivered to customers.

The industrial-era manager operatedwithin a hierarchical entity, typically withseparate marketing, engineering, manufac-turing, sales, accounting and finance func-tions. Hierarchical entities can grow verylarge, but tend to be slow moving becausethe separation of functions impedes fast ac-tion. Industrial-era managers figure the"optimum" way to perform manufacturingor processing tasks and build the entity'scontrol system to "lock in" the optimum pro-duction process. In this system, there arestandard productivity rates, and variationsare systematically suppressed.

Management's job in an information-era

5A JOURNAL OF ACCOUNTANCY, NOVEMBER 1991

company is much different. It attempts toorganize as a network instead of a functionalhierarchy. It no longer focuses primarily ona fixed basket of assets bequeathed by priormanagement (such as raw materials, fin-ished goods and plant and equipment) andon the relatively fixed goals of productionand distribution. Instead, managementmust focus increasingly on information as-sets (such as human resources, R&D, in-formation systems, data on customers'needs and capacity for innovation) and onthe shifting goals of shorter product designand production cycles, improved qualityand greater customer satisfaction.

U.S. ACCOUimNG MODiLiFUNDAMEWTAUY INDUSTRmDespite new managerial tasks, accountantscontinue to supply the same industrial-erafinancial statements—statements of re-sources (balance sheet) and changes in re-sources (income and cash flow statements).Cost accounting models continue to rein-force the fixed-production-processes model.The very account-coding structure followedreinforces the hierarchy: The digits in ageneral ledger account-coding structurerepresent the levels of the hierarchy—theleft digits are high in the hierarchy (divi-sional, for example), and the right digits arelow (specific activities on the factory fioor).

New accounting models are needed tomeasure rates of change in resources andprocesses and to account for the off-balance-sheet assets so vital to the information-eraenterprise. Management today would ben-efit from continuous measures of businessactivity in place of summaries preparedafter the fact. Exhibit 2, page 58, comparesthe features ofthe industrial-era accountingmodel with those of a possible (but yet un-developed) information-era model.

Companies adapting to the informationera are aware their accounting systems donot provide the types of information they

need to manage. Some are experimentingwith systems that measure not only tradi-tional financial attributes but also attri-butes such as customer satisfaction,internal processes (productivity, qualityand cycle time) and capacity for innovation(learning curves and conversion of researchto salable products).

A key difference is the financial measuresdo not focus on earnings per share (EPS),return on assets (ROA) or return on equity(ROE). Instead, they focus on shareholdervalue using concepts introduced by AlfredRappaport in his book, Creating Share-holder Value, published in 1986. These in-clude value growth duration, sales growth,operating profit margin, income tax rate,working capital investment, fixed capital in-vestment and cost of capital. Shareholdervalue can show results radically differentfrom the earlier measures. A company canhave rising EPS, ROA and ROE and yetshow declining shareholder value.

INJURIES FROM ACCOUKnNOMOPil PIFICIINCIESA number of constituencies have importantinterests in the accounting model, includinginvestors, management and auditors. Theidentified deficiencies in the current modelinjure each of these constituencies in a spe-cific way.

Investors. Although too httle is knownabout the degree to which the currentmodel actually serves the interests of inves-tors, it is known investors obtain and relyon data from many sources other than thefinancial statements. Analysts meet withmanagement and follow what they canabout the company's research, the qualityof its products and its cycle times. Thesematters are treated as significant by thefinancial press. No one denies they are rel-evant. Yet their absence from financialstatements means the statements cannot befully relied on to judge stewardship. Inves-tors either go without such information orare forced to rely on presentations that maybe oral, unaudited and impressionistic.Such presentations are not distributed asefficiently 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 billrate—can be used as a starting point to pre-dict companies' cost of capital. To that rateare added premiums for economic risk andinformation risk—the risk that economicrisk is misperceived because of incomplete.

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insufficiently relevant or insufficiently re-liable infonnation. The less certain the po-tential investor is about his or herunderstanding of the economic risk, thehigher the information-risk premiumcharged. Conversely, the more certain thepotential investor is about understandingthe economic risk, the lower the informa-tion-risk premium. Today's periodic, his-torical, cost-basis financial statements donot provide as complete a set of relevantentity-specific data as is feasible to enablepotential investors to understand the eco-nomic risk of investing; this undermines thespirit of management's discharge of its fi-duciary responsibilities to shareholders.

Although the full effect of industrial-erapublic reporting on management is un-known, there is reason to suspect it is notgood. An intense focus on the informationthat might be usefully reported for an in-formation-era enterprise should bring tolight the types of data that can serve man-agement's decision making.

Auditors. An audit report is only as use-ful as the audited information. If financialstatements gi-ow less relevant, so do auditsof those statements. Already there is grow-ing evidence of price competition in themarketplace for audits. This could be a signaudits have begun to lose their role in di-minishing information risk because the au-dited financial statements, even whencredible and reliable, are less effective indiminishing information risk.

Standard setters. The Financial Ac-

counting Standards Board has lost some ofthe constituency support it had when it wasfounded, not necessarily in numbers of con-stituents but clearly in their degree of en-thusiasm. Moreover, the P^ASB has beencriticized for adopting requirements thatare unnecessary, too frequent and too de-tailed and that fail to meet the test of pro-viding benefits greater than costs. Therelevance of the required information,which can weigh so heavily on the benefitsside ofthe equation, should be a more cen-tral part of such debates.

In the long-term, the FASB's supportwill depend on how it performs the secondofthe activities designed to achieve its mis-sion, namely, "tto] keep standards currentto refiect changes in methods of doing busi-ness and changes in the economic environ-men t . " As seen, the re have beenmomentous changes since the current ac-counting model was developed. Respondingto the transformation from an industrial- toan information-era business world couldshift the dialogue about the FASB's per-formance more toward what infonnationbest serves users at this point in the econ-omy's evolution.

The U.S. economy. Ways in which thecurrent accounting model keeps companiesfrom adapting to the information-era econ-omy have been noted. The model does notprovide information that could improve theefficiency of capital allocation, does not min-imize the information-risk factor in the costof capital and can lead to faulty economic

EXECUTIVE SUMMARY• THE CURRENT FINANCIAL ac-counting model in the United States re-sults in financial statements insufficientto evaluate information-era companies.• NEW TECHNOLOGY REQUIRESnew types of business and investmentdecisions to be made, creating a need fornew types of accounting information.• BECAUSE MANAGEMENT'S JOBin an information-era company is differ-ent, management must focus attentionon information assets such as human re-sources and research and development.• NEW ACCOUNTING MODELS areneeded to measure rates of change in re-sources and processes and account foroff-balance-sheet assets, which are vitalto information-era enterprises.• INVESTORS, MANAGEMENT and

even auditors are harmed by the defi-ciencies in the current accounting model.Problems also are created for the FASBand for the U.S. economy as a whole.• THE FASB NEEDS TO TAKE aleading role in studying investors' infor-mation needs and working to educateothers about the information-era model.Management, investors and CPAs alsocan play an important part in pushing fora new model.• BECAUSE OF ITS INFLUENCE,the SEC also can take steps to help theUnited States adapt to the information-era model.• IN THE FUTURE, the language ofthe information-era model can be used toaddress current and coming problems aswell as business opportunities.

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decisions. Unrecognized human resourceassets, for example, can tempt manage-ment to take a short-term earnings lift bydismissing or discouraging skilled person-nel, which could be expensive when short-ages in skills and deficits in experiencehamper future growth and profitability.

Economist Lester Thurow has said theUnited States, where R&D is chargedstraight to income, alone among major com-petitors has an R&D curve that rises andfalls with the business cycle. This suggestsR&D that can provide future economic ben-efits should be capitalized, rather than au-tomatically charged against earnings.

WHAT SHOULD BE PONE?

FASB. The FASB should devote more re-sources to studying investors' needs and ed-ucating its constituencies about theinformation-era model. This could be ac-complished in part by a study that alsowould test the argument that investorsneed the kind of data the information-eramodel would provide. The study should ex-amine the relationships among

• Entity-specific information from gen-eral-purpose financial statements.

• Entity-specific information investorsactually apply in decision making.

• Non-entity-specific information used indecision making (such as the course of theeconomy and ofthe industry, potential newcompetitors).

A parallel study should focus on the in-formation top management uses to makedecisions, comparing it to what is madeavailable through financial statements. Thetraditional distinctions between managerialand financial accounting should not meanone cannot leam from the other. Whateverthe differences between the two sets of in-formation, both should at least be based oncompatible assumptions about the econom-ics of business enterprises. Moreover, topmanagement 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 torecognize operating factors that have pre-dictive value, such as human resource as-sets, cycle times, innovation, productivityand quality.

In evaluating the trade-offs between therelevance and the reliability of informationto be presented to users, the FASB shouldconsider not only the relevance and reli-ability of the data that might newly be re-quired but also whether investors are

depending on less reliable sources for thesame information. The comparison to his-torical cost may make the new informationseem soft, but the comparison to other,even softer, information investors areforced to rely on might make it seem rela-tively hard. It would also throw light oninvestors' needs—the FASB will be judgedby its service to users of financial reports.

Management. Management should seekbetter performance measures for internaluse, as some entities are already doing. Itis clearly in their interests to have suchmeasures for managerial purposes, andthey may in time contribute to general-pur-pose reporting. Management could take theinitiative by experimenting with voluntarydisclosures that fit the information-eramodel. They would be helpful to the FASBas well as to investors, partly because theywould educate FASB constituents aboutthe new model.

Such voluntary disclosures might not bean altogether off-putting prospect to man-agement. The opportunity to recognize newassets, such as human resource assets, forexample, might be welcomed, demonstrat-ing additional strengths to the investmentcommunity.

Auditors. It would be in auditors' best

EXHIBIT 1Methods of wealth creation

Three fundamentally differentmethods of wealth creation. Foreach, a different form of accountinginformation is required.

8000 BC 1650 1955 Time

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EXHIBIT 2

Accounting models

Industrial era

Measures resources.

Measures processes.

Measures tongibles.

Focuses inwardly onproduction costs.

Woits for events (transoctlons)to occur before measuring.

Reinforces the hierarchy.

Information era

Meosures rates of chongein resources.

Meosures rates of chongein processes.

Meosures intangibles.

Focuses outwardly oncustomer values.

Meosures processes inreal time.

Enables the netv/ork.

interests to promote the information-eramodel because they have so much at stakein the viability and usefulness of auditedpresentations. Such efforts need not be re-stricted or even primarily devoted to lob-bying the FASB. Perhaps the best wayCPAs could promote the information-eramodel is by demonstrating they can reporton the new disclosures and thereby provideinvestors with assurance of the reliabilityof the measures.

There is a precedent for this kind of work,as anyone who has followed the history offorecasts and projections is well aware.Once demeaned as too soft for presentation,forecasts are now routinely presented withCPAs' reports. Moreover, the precedentshould help technically. The basic conceptof evaluating the reasonableness of man-agement's assumptions may be the key toreporting on the disclosures that emergefrom the information-era model.

Investors, Investors can do more than bethe passive subjects of study. Over thecourse of standard setting since the FASBbegan its work, investors have been in theironic position of being both the featuredconstituency in the conceptual frameworkand the least active constituency in stan-dard setting's due process. That should end.

Participating in standard setting's due-process procedures, with their discussionmemorandums, exposure drafts and hear-ings, can take a good deal of time. If thattime commitment is the reason for inves-tors' lack of participation, selective inter-vention would be an alternative. Investorscould focus their recommendations andcomments on the FASB's agenda and also

provide feedback on the relevance of theinformation provided under current stan-dards. In this way they could make the kindof contribution only they can make, provid-ing hard data on investors' needs.

Of course, investors and their represen-tatives may not see it in their interests tohave information-era disclosures univer-sally available, because they sell and usetheir personally developed information onthe value of securities. If that is true andwill be a fixed condition, it must be acceptedfrankly, and investors' needs determinedwithout their cooperation.

Securities and Exchange Commission.The SEC has the power to take the initia-tive on adapting to the information-eramodel, and it also can influence the FASBto move in that direction. As a public-sectorbody, it has perhaps a greater obligation toestablish a defensible basis for its actionsthan even a quasi-public body like theFASB. It would therefore be appropriatefor the commission to research the need foradapting to the information-era model itselfor urge the FASB to do so.

There is a precedent for SEC researchon such issues: the Advisory Committee onCorporate Disclosure, whose report was is-sued in 1977. The committee was the SEC'sinitiative: Its charge was very broad and itsreport was well received and influential. Inaddition, in serving investors through thedisclosure system, the SEC has taken stepsin the past on grounds that the present ac-counting model has limitations, for exam-ple, the requirement for management'sdiscussion and analysis.

Finally, excessive legal liability exposurediscourages management from reportingnew information and auditors from attest-ing to it. The SEC could work toward lia-bility relief (for example, by establishingsafe harbors), thus clearing the way for thenew model's expanded disclosures.

THl lAMOUAOE OF BUSINESSAccounting has been called the language ofbusiness, but there is good reason to doubtthat it alone merits that sobriquet today.In literature on modem management andbusiness, another language has taken itsplace beside accounting. It is the languageof the information-era model, used to ad-dress the current and coming problems andopportunities of business. The time hascome for accounting to study that language,to select from it what elements can be ef-fectively measured and reported and to de-fine how to present it uniformly. •

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