Economic “Reality” and the Myth of the Bottom Line

Louella Moore

INTRODUCTION

Why do accounting practitioners, users, and standard setters continue to pursue a mythi- cal, determinate “bottom line” in spite of the known limitations of accounting mea- sures? Accounting standard-setting bodies espouse the usefulness of a consistent con-

ceptual framework, and have derived multiple frameworks in the last century. Yet none of them seem to last. Emerson �1841� notes:

a foolish consistency is the hobgoblin of little minds, adored by little statesmen and philosophers and divines. With consistency a great soul has simply nothing to do.

Ironically, accounting standard setters manage to have plenty to do by simply changing from one consistent, but problematic, framework to another. American standard setters adopted a set of historical cost principles for a time, attempted to switch to fair value until they were faced with a practitioner backlash, then allowed a mix of historical and other valuations, and are now on a trajectory toward fair value. Similar to prior attempts, the new asset/liability-based fair value approach espoused by the International Accounting Standards Board �IASB� and the Financial Accounting Standards Board �FASB� is getting a lukewarm reception �Benston 2008; Kvifte 2008�. It seems the accounting profession simply cannot settle on a logical, consistent framework for long. This paper argues that the inability to maintain agreement may be tied to the stark contrast between the inherent paradoxes of accounting and the profession’s insistence on pursuing the myth of a determinate bottom line. If basic elements of the economic “reality” are in fact indeterminate and paradoxical in nature, perhaps it is understandable that a consistent theoretical framework is elusive.

This paper begins with a brief summary of some previously iterated limitations or problems in accounting measurement. The main section of the paper then draws on recent discussions between physicists and Buddhist philosophers exploring the nature of real-world phenomena. The physics and philosophy dialogs to date have focused on inherent problems in the objective measurement of phenomena and suggest that similar challenges exist in the accounting profession’s efforts to measure economic “reality.” The discussion on the indeterminate nature of phenomenal reality is

Louella Moore is a Professor at Arkansas State University.

Accounting Horizons Vol. 23, No. 3 American Accounting Association 2009 DOI: 10.2308/acch.2009.23.3.327 pp. 327–340

COMMENTARY

Submitted: September 2008 Accepted: April 2009

Published Online: August 2009 Corresponding author: Louella Moore

Email: [email protected] 327

followed by conjectures as to what may be causing the accounting profession to cling so tightly to the prevailing myth of the bottom line. The paper ends with implications for standard setting, practice, education, and research.

PROBLEMS WITH ACCOUNTING MEASURES Table 1 lists significant problems with accounting measures that have been previously iden-

tified in the accounting literature and business press. The list is not intended to be exhaustive, but to be indicative of broad problem areas in accounting.

Limitations of Numeric Scales and Measurement Approaches The first limitation is the mix of numeric scales found in accounting reports. Stevens �1946�

argued that most measurements can be classified as nominal, ordinal, interval, or ratio. In account- ing practice, classifying an object under a specific account title is a nominal measurement process, while numbers on the financial statements may be ordinal, interval, or ratio in scale. Stevens saw the inherent properties of the scales as a constraint on the types of valid comparisons that can be made using financial data. According to Bierman �1969, 141�:

TABLE 1

Problems with Accounting Measures

Problem Short Description of Problem

�1� Measurement Scales: �Bierman 1969�

Nominal, ordinal, interval, and ratio scales: Prevalence of nonratio scales in practice limits the ability to assess distances between measures.

�2� Measurement Approaches: �Edwards and Bell 1961; Chambers 1966; Sweeney 1930�

No agreement on available approaches: �a� cost, with or without price-level adjustments and �b� value; �1� replacement value; �2� realizable value; �3� net realizable value; �4� discounted cash flows; and �5� value of similar productive capacity.

�3� Traditional Transactions Income versus Economic Income: �Hicks 1939; Mitchell 1967; Revsine 1970�

Transaction approach is a weak substitute for the opportunity costs hypothesized in pure economic theory.

�4� Incorrigibility of Allocations: �Thomas 1969; Devine 1985�

It is impossible to derive a single defensible basis for allocating costs.

�5� Transfer pricing: �The Economist 2007�

Transfer prices can move income from department to department—distorts tax and responsibility accounting systems.

�6� Market adjustments are often counterintuitive: �Brubaker 2008; Katz and Reason 2008�

Market adjustments for liabilities in companies with declining credit worthiness defy economic common sense.

�7� Circular effect and inability to audit instruments based on future market conditions: �Benston 2006�

Many types of financial instruments cannot be objectively valued on an ongoing basis; reported values may cause market changes.

�8� Management incentives for income manipulation: �Core et al. 2003�

Reward systems based on market or accounting performance are associated with opportunistic choice of accounting procedures.

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If accounting limited itself to presenting the amount of cash in the bank, a true measurement might be attainable, but when the scope of accounting is broadened … the possibility of finding a true measure falls out of reach.

Readers of financial statements can reach inappropriate decisions from accounting data when they fail to consider the type of number scale they are using. In publicly available accounting reports it is often unclear what numbers are on an ordinal, interval, or ratio scale. Because different companies may use different methods of measuring assets, numbers that in a perfect world would be comparable on a percentage basis, as in the ratio scale, may be capable of giving only interval or even ordinal level comparisons in practice. Krantz et al. �1971� expanded on Stevens’s �1946� classification to consider nonlinear structures, while Sarle �1995� demonstrated that measures can have properties that lie somewhere between the four classical scales and that data sets may measure different attributes at different times for different purposes.

A second problem is that while most conceptual frameworks are built on a framework of decision usefulness, accountants do not agree on what kind of data is most useful. Cost and value approaches are most common. The cost approach is usually viewed as more objective or reliable than a value approach, but even cost-based approaches can contain many subjective elements. Value measurements may take many forms such as replacement value, realizable value, discounted cash flow, value of similar productive capacity, or opportunity costs, while initial outlay costs can be adjusted for changes in general price levels �Sweeney 1930; Chambers 1966; Edwards and Bell 1961�. Which cost or value measure is preferred depends on which limits one can accept for a given decision; yet financial statements are intended to be helpful in a variety of decisions.

The replacement value approach is usually more subjective than historical cost, particularly if the product has to be replaced through internal manufacture or through development such as for oil or mineral exploration. Another criticism of replacement cost is that for buildings and other types of long-lived assets it would be unreasonable to replace the asset without upgrades; there- fore, the replacement value of the same equipment may be just as irrelevant as historical cost. Realizable and net realizable values represent an attempt to measure how much cash would be received if an asset were sold. A distinct criticism of this approach is that while realizable or net realizable value might give an approximation of the value of assets in an orderly liquidation, this is irrelevant data if the company plans to continue using the asset. Discounted cash flow �DCF� uses a discount rate to determine the present value of expected future cash flows. The DCF technique attempts to measure the value in use rather than the value to purchase another asset or the flows from disposal. Still, management has incentives to make opportunistic future cash flow estimates, and these flows often cannot be estimated on an asset-by-asset basis. The cost of similar productive capacity approach modifies replacement cost to recognize that asset replacement usu- ally involves purchasing updated models with improved technology. This approach will typically use the opportunity cost of buying new equipment in the income statement. Yet the company is in fact still using the low-tech model rather than an improved model. Does it really make sense to report income statement costs or balance sheet values for updated equipment the company does not yet own or use?

Difficulties in Measuring Income A third problem is that the accounting profession has not really reached closure on what we

mean by income. One approach is to assume that accounting is attempting to operationalize economic concepts of wealth on a continuous basis. Another approach is that accounting should reflect the effect of transactions between the firm and other entities. Hicks �1939� sees economic income as the amount an individual could consume during a week and still be as well off at the end of the week as at the beginning. The Hicksian or economic approach to income is broader in

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scope and more subjective than the transaction-based approach. The Hicksian economic or wealth- based approach suggests that increases or decreases in income can arise from changes in the underlying value of one’s assets or liabilities even in the absence of an exchange transaction. According to Hicks, even psychological assessments that the market is about to take a downturn might cause one to feel less wealthy. Thus economic measurements are not separate from the psyche of the owner, accountant, or other market players.

Transaction- and wealth-based approaches affect the income statement and the balance sheet very differently. The Hicksian approach assumes that changes in the underlying perceptions of asset and liability values are part of income. The transaction-based approach to accounting waits for a subsequent exchange event to provide confirming evidence of value changes before they are admitted to income.

On its surface, the recent FASB and IASB evolution to an asset/liability approach seems to move the accounting profession closer to economic theory. However, the asset/liability model fails to capture the essence of economic income because fair values are not always the same as opportunity costs �Mitchell 1967; Revsine 1970�. Accounting practice ignores the implication from economic theory that if markets were completely efficient there would be no sustainable economic profits as competition would quickly drive all firms to a common level. Beaver and Demski �1979� as well as Bromwich et al. �2008� note that if markets were truly perfect, account- ing measures would be redundant.

The Problems of Allocation and Transfer Pricing Thomas’s �1969� analysis of joint product and other allocation schemes found that all attempts

to allocate or apportion costs to multiple periods, departments, or other cost objects are “incorri- gible.” Thomas concluded that it is impossible to derive a single noncontroversial approach to accounting allocations and that the potential variations in practice can cause such significant distortions that they should be discontinued. In an American Accounting Association study, Devine �1985� also concluded that all accounting allocations are arbitrary or impossible. Still, Thomas and Devine’s conclusions have not hindered the development of expensive activity-based costing systems built on the idea of making overhead allocations more and more detailed. Although activity-based costing can provide some benefits if it better identifies fixed versus variable costs, fixed and variable classifications are based on subjective views of the length of the typical decision horizon. Likewise, it is well-known that if there are no externally imposed limits on the type of transfer prices used between organizational departments or between related companies, manage- ment has incentives to park income in fortuitous tax venues �The Economist 2007�.

Counter-Intuitive, Unauditable, and Opportunistic Accounting Measures The FASB has gone back and forth on whether gains and losses on advance refundings of debt

should be treated as extraordinary, apparently because these adjustments are counter to common- sense impressions of economic reality. When a company’s credit worthiness declines, its interest rates rise. Under the asset/liability approach, as market values decline the company can book a gain. Thus, companies are in effect rewarded for their declining ability to pay their debts �Brubaker 2008; Katz and Reason 2008�. In addition, Enron clearly demonstrated that many companies today are buying and selling financial instruments with values contingent on future events that cannot be reliably measured on an ongoing basis �Benston 2006�. Yet being required to report all instruments at some version of current value provides incentive to select measures because of their potential to influence future values. Furthermore, the agency theory literature provides convincing evidence that use of reward systems that rely on accounting or market mea- sures tend to result in opportunistic selection of accounting techniques �Core et al. 2003�.

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PERSPECTIVES ON “REALITY” FROM PHYSICS AND BUDDHIST PHILOSOPHY

Accountants are faced with significant challenges in their attempt to provide true and fair measures of economic reality. Physicists commonly deal with problems inherent in moving from pure theory to the practical measurement of physical phenomena. Buddhist philosophers likewise have a longstanding tradition of applying rigorous logic to identify what is “real” and the limits of what can be deduced about so-called “real” phenomena. Insights from quantum mechanics and Buddhist philosophy may give a new perspective on some of the underlying issues inherent in accounting measurement problems.

The Quantum View of Phenomena

Prior to the last century, physicists hoped that explanations of the workings of all natural phenomena could be reduced to deterministic mathematical formulas. After all, Newtonian for- mulas had been very useful in calculating trajectories, speeds, thrust, and other data useful in creating the machines used by the emerging industrial complex. Toward the end of the 19th and the beginning of the 20th century, physicists came to realize that in many cases the old formulas were unacceptably imprecise.

The old theories of physics assumed that the world was made up of phenomena that could always be measured precisely, if the proper tools could only be devised. Although some objects might be very small, it was thought that all measurable phenomena could be conceptualized as distinct units. The term quantum mechanics is attributed to Max Born �Bernstein 2005; Heisenberg 1927�, but Max Planck, Albert Einstein, Neils Bohr, and many other physicists also contributed to the development of an understanding that phenomena act very differently at the quantum, the subatomic, level compared with what one would expect from larger objects �Einstein 1934; Bohr 1958; De Broglie 1953; Beller 2001�. One basic idea from quantum theory is that subatomic phenomena can act as either waves or particles depending on the measurement technique. Accord- ing to Werner Heisenberg’s �1970� uncertainty principle, it is impossible to know precisely both the position and momentum of a quantum object. The act of observing actually changes the momentum. Furthermore, although the changes in momentum can be estimated probabilistically, a portion of the change is inherently random.

Physics models are coming to be widely used as tools for valuing financial instruments on Wall Street �Derman 2004; Ouellette 1999�, and Demski et al. �2006� have suggested possible applications of physics to accounting. Palmrose �2008� predicts that insights from physics may provide the next major research paradigm for financial accounting. Still, Bernstein �2005� notes with some irony that Scholes of Black-Scholes fame and his colleagues relied on their physics- based theoretical models to create a $3.65 billion real-world crisis for the Long Term Capital Management Fund because they forgot a basic tenet of quantum mechanics—they treated proba- bilistic investor behavior as if it were deterministic.

A second tenet of quantum mechanics is that at the subatomic level discrete objects do not exist. This parallels the problem of establishing objective boundaries in accounting. Accounting may attempt to measure the behavior of a single manager, a legally defined corporation, or a consolidated entity, but external effects always remain. While agency theorists define a firm as a nexus of contracts for research purposes, that definition is of little help in measuring financial statement items. In practice, financial accountants must posit some form of arbitrary reporting entity even though firms are inherently interconnected with other economic interests.

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The Nature of Phenomena in Buddhist Philosophy Buddhist philosophers and physicists have recently entered into formal dialogs to explore the

parallels between quantum mechanics and Buddhist philosophy �Hayward and Varela 1992; Dalai Lama 2005; Mansfield 2008�.1 In particular this paper considers the Buddhist concepts of empti- ness �shunyata�, signlessness �animitta�, and aimlessness �apranihita� �Hanh 1998, 146–155; Rab- jam 2007, 99� to explore how these ideas may mirror problems in accounting measurement.2

The concept of emptiness �shunyata� is central to Buddhist thought. The term is used to signify that all phenomena are interdependent. For example, humans cannot exist without air, which comes from plants, which in turn depend on soil, sunshine, insects for pollination, and so on, ad infinitum. Emptiness does not mean that objects of measurement are nonexistent, but that it is impossible to understand fully any phenomena independent of other entities that form a web of causal streams. This mirrors the physics and accounting problems of boundaries. The boundaries of presumed objects of accounting measurement are not as fixed as they might first appear. Traditional financial reports rarely distinguish an organization’s current performance from the structural benefits or burdens resulting from prior management action or the state of the overall economy. Some have proposed expansion of accounting to include more social and environmental issues �Bowen 1953; Goyder 1961; Belkaoui 1984; Tinker 1985; Mathews 1997; Quarter et al. 2002�. Yet how can we resolve the conundrum that at some point accounting for anything becomes accounting for everything?

The Buddhist concept of signlessness �animitta� focuses on the idea that no description of characteristics can ever fully describe anything. The map can never completely replicate the territory. While we can call an object a chair, or a collection of boards, plastic, and fabric, the very act of describing will in some way either omit some of the object’s potentialities or influence the listener as to the capabilities of the object. Solomons’ �1978� description of accounting as financial cartography gets at these same limitations. The idea of signlessness coupled with emptiness en- compasses the basic philosophical problem of nonduality �Loy 1988�, which is the impossibility of distinctly separating subjects and objects. Accounting measures are inherently understood in a social context, with the measures influencing and being influenced by the surrounding society. It is impossible to make a perfect separation between the object being measured and the influence of the accounting measures.

The third Buddhist concept of aimlessness runs counter to popular business culture. Aimless- ness implies that setting and running after goals is overrated in the long term. Yet modern corpo- rate management and corporate accountability is firmly based on the idea of setting goals and measuring the results against those goals. Still, the concept of aimlessness mirrors conclusions in pure economic theory that eventually all businesses should devolve to a state of no true economic gain after other entities have studied and appropriated the techniques of corporate best practice.

Taking emptiness, signlessness, and aimlessness to their logical conclusion for social account- ability, if a positive income persists long term it suggests the market allows externalities and exploitation of workers, while a loss might be equivalent to a charitable contribution to the overall society. Thus, it is unclear that traditional accounting measures are a proper measure of value to

1 Buddhism is commonly associated with religious debates on theism versus atheism, the soul versus no soul, and concepts such as nirvana and how it might be attained, if at all. This paper focuses not on religious elements but on secular, philosophical inquiry concerning the nature of phenomena using concepts that happen to have been derived from Buddhist scholarship.

2 In the original Buddhist texts these concepts were never applied to accounting issues. The Hanh text, though not an original Buddhist scripture or sutra, is the most accessible English explanation of the secular aspects of these three concepts. These three themes run through classic works such as the Lotus Sutra �Saddharma Pundarīka Sutra�, the Heart or Perfection of Wisdom Sutra �Prajñāpāramitā Hrdaya Sutra�, and the Diamond Sutra �Vajracchedikā-prajñāpāramitā-sutra�.

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society. From a moral standpoint, running after gain and worrying about loss is the Buddhist equivalent of a deadly sin in the Christian tradition. Still, achieving a profit and avoiding a loss is widely accepted as the business raison d’etre in the West and the East alike even though in perfectly efficient markets real profits should quickly devolve to zero.

So how can these two approaches be reconciled? Physicists have concluded that the rules differ for larger phenomenon compared with the activities of their subatomic components. In contrast, Buddhist philosophers suggest their conclusions apply to larger phenomena as well, but they attempt to reconcile the counterintuitive ideas of emptiness, signlessness, and aimlessness by distinguishing between relative and ultimate truths. At the ultimate level Buddhist philosophy implies that �1� accountants have nothing to measure �emptiness�; �2� what we are measuring cannot be fully described �signlessness�; and �3� too much focus on individual profit maximization may run counter to general social welfare �aimlessness�. At the relative level, society accepts some artificial boundaries for firms, using certain measurement conventions of positive cash flow or income as indicators of firm performance, even though they may be measured only imprecisely by operational rules that reflect the conventions of social value �Beaver and Demski 1979; Demski and Sappington 1990�. The concepts of emptiness, signlessness, and aimlessness taken together suggest that the popular call for true, fair, and fully transparent accounting systems can be achieved in a relative but not an absolute sense.

Buddhist ethics have had less influence on accounting than those of Abrahamic origin �Liya- narachchi 2008, 121; Jayasinghe and Soobaroyen 2007�. One aspect of Buddhist and other Eastern ethical views is that the public good should take precedence over individual interest because of emptiness; that is, mutual interdependence. Although the assumption that individuals work toward their own self-interest has been inherent in classical economics, Eastern ethical concepts of inter- dependence are not at odds with modern game theory, which has shown that the group realizes the highest good when individuals choose to override mundane self-interest and work toward mutual social goals �Fernandez and Bierman 1998; Gintis 2000�.

The Prevailing Myth of a Bottom Line Having discussed the known problems or limitations in accounting and two bodies of work

that suggest that the interdependent nature of phenomena precludes perfect measurement, it is important to ask why the myth of the “bottom line” is so persistent. This section posits four possible explanations: �1� Western cultural bias in accounting; �2� innumeracy and ritual; �3� artifacts of a weak credentialization movement; and �4� inordinate faith in market equilibrium as a basis for social justice.

Cultural Bias The concept of shunyata �emptiness�, or interdependence, appears in various Eastern tradi-

tions such as Hinduism and Taoism, but less commonly in Western cultures. The Western cultural bias is that things should have an answer. Westerners think the accountant should be able to say whether product A is making or losing money and how much. Westerners want puzzles to have a solution. Riddles that go round and round are unacceptable. Readers of financial statements do not want to hear that the profit for the year was somewhere between a negative $5 million and a positive $30 million. Furthermore, it is not uncommon in Western society for members of the press and the general public to work to place specific blame on someone. They just want to hear how much money the company made; they do not want to hear that it was the fault of the overall economy, or a weather event beyond the company’s control. If there is a financial reporting crisis, someone needs to be blamed, be it the CEO, the CFO, or the auditor. The mindset that a single, noncontroversial bottom line exists is common among the functionally innumerate. It is no less

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common among the financial elite who use the very myth of a determinate bottom line as the basis for lawsuits to recoup stock market losses.

Even though Eastern cultures generally tolerate the notion of interdependence better than the popular Western mindset, the Western accounting bias has extended to Eastern countries as well. Recent efforts at accounting standard setting in China and Japan are not significantly different from those of the FASB and IASB �Deloitte 2006; Study Group 2004�. The Western bias that accounting reports represent the bottom line cuts both ways. If the public chooses to believe that the bottom line is precise and noncontroversial in spite of considerable evidence to the contrary, this enhances the reputation of accountants as answer machines �Burchell et al. 1980� in the short term. But if accountants are unable to provide determinate answers because of the inherent nature of economic phenomena, this might explain recurring crises of confidence.

Innumeracy and Ritual Innumeracy has been defined as “an inability to deal comfortably with the fundamental

notions of number and chance” �Paulos 1988, 3�. This bias against numeric information prevents users from looking too closely at the techniques behind accounting numbers. Not only is the general public biased against numeric information, but even accounting practitioners seem to have little interest in the conclusions from accounting academic research when it is based on high-level mathematical models �Elliot 1991; Bricker and Previtts 1990�. Paulos �1988� posits that most people really do not like numbers, do not care to delve into how the numbers were calculated, and are not interested in debating the deficiencies of numeric measures. It is simply easier to accept accounting numbers as a definitive bottom line. Feldman and March �1981� maintain that account- ing’s ro

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