A
Social Science of Contemporary Value-Based Accounting:
Economic
Foundations of Accounting for Financial Instruments
Junji Ishikawa
Graduate School of Business, Osaka City University, Japan
In this paper, firstly the present-day fair value accounting for financial instruments is placed in a proper historical perspective by outlining various specific forms of what may generally be regarded as “value-based accounting.” This is followed by an argument to distinguish between inherently different concepts of capital in economic theory, i.e., real capital and loan/fictitious capital, in order to identify the economic foundations of the contemporary form of value-based accounting. The paper goes on to explain that the contemporary accounting problems concerning financial instruments/derivatives are but a manifestation of the failure of the traditional framework of corporate accounting to adapt to the accelerating development of fictitious capital. It is then argued that the existing framework for accounting recognition and measurement or any simple extension of the framework, such as the “realizability” criteria advocated by the FASB, cannot be expected to provide the theoretical basis for the contemporary accounting for financial instruments. This argument would lead us to study the possibility of coexistence or hybridization of the different frameworks of capital/ income determination reflecting the difference in their economic foundations. And finally, the paper underlines the importance of economic and historical perspectives in addressing the issues of contemporary value-based accounting as a social science of accounting. Supplementary discussions are provided in Appendix A on the need for another framework of accounting where financial assets/liabilities are concerned, and in Appendix B on a choice of economic theories and the respective accounting perspectives which they offer.
Introduction
The
16th Convention of the Japan Society for Social Science of Accounting (JSSSA)
met in October 2001 in Tokyo to discuss the designated theme of “Accounting
Transformations in the 21st Century: Challenges for Accounting as a
Social Science.” The objective of
this author is to discuss what the theme calls “accounting transformations” in
terms of today’s "value-based accounting", which is opposed to a traditional
“cost-based accounting”, and to do so in the context of capital/income
determination, arguably the most important task in corporate accounting. And in keeping with the subtitle of the
theme that focuses on “challenges for accounting as a social science,” this
paper aims to present a case for a social science of contemporary value-based
accounting.[１]
In this paper, an attempt is made at the outset (Section 2) to place the present-day value-based accounting for financial instruments in a proper historical perspective by outlining various specific forms of what may generally be regarded as value-based accounting. This is followed by an argument to distinguish between inherently different concepts of capital in economic theory, i.e., real or industrial capital (in the real economy) and loan/fictitious capital (in the financial economy) in order to identify the economic foundations of the contemporary form of value-based accounting geared primarily to financial instruments (Section 3). The paper goes on to explain that the contemporary accounting problems concerning financial instruments/derivatives are but a manifestation of the failure of the traditional framework of corporate accounting to adapt to the accelerating development of fictitious capital (Section 4). It is then argued that the existing framework for accounting recognition and measurement, or any simple extension thereof similarly predicated on real capital, cannot be expected to properly measure outcomes from fictitious capital, to the extent that measuring outcomes from fictitious capital qualifies as a form of income determination set apart from measurement of outcomes from real capital and also to the extent that the outcomes from the two types of capital are fundamentally different in terms of their economic substance (Section 5). And finally, the paper underlines the importance of economic and historical perspectives in addressing the issues of contemporary value-based accounting for financial instruments as part of a social science of accounting and identifies challenges for further research (Section 6).
Supplementary discussions are provided in Appendix A on the need for another framework of accounting where financial assets/liabilities are concerned, and in Appendix B on a choice of economic theories and the respective accounting perspectives which they offer.
Variant Forms of Value-based Accounting
A historical observation reveals several distinct lines in the overall lineage of what can generally be termed “value-based accounting.”[２] The first such variant was “price-change accounting,” a form of value-based accounting that was hotly debated in the 1970s in connection with differing concepts of capital maintenance. This form of accounting addressed non-monetary assets, whose market price changes could be characterized as one of constant increase in individual asset prices. A second variant is “fair value accounting”, another form of value-based accounting which arose in the mid-1980s and has culminated in its present-day prominence, dealing primarily with financial instruments/derivatives. Its focus has been on financial assets and liabilities, instead of non-monetary assets, and fluctuations in the value of those assets and liabilities have typically involved both upward and downward movements[３]. A third variant, “impairment accounting,” is characterized by significant declines in individual asset value stemming from declining profitability. A full-fledged discussion of impairment accounting in Japan is now under way.
If the price-change accounting of 1970s vintage involved issues of accounting for real assets in highly inflationary economies, then the present-day fair value accounting focusing on financial instruments would involve accounting problems in financial markets exposed to the risk of fluctuating securities prices and interest rates. And, as far as Japan is concerned, impairment accounting may be characterized as one addressing fixed assets as an accounting problem in deflationary economies. While sharing a common strain of addressing market value changes, each of the three variants thus deals with changes that are mutually distinct in their patterns of price change and economic foundations. In all three cases, however, what mattered were not only the question of financial transparency or disclosure of economic substance and financial risk but also one of capital/income determination[４].
It is important here to note that the varying forms of “value-based accounting,” each with differing characteristics, have historically emerged under differing economic and social conditions. A fourth variant of value-based accounting, now apparently coming to the fore, could well involve intangible assets. As distinguished from monetary assets, fixed assets and other tangible assets, intangibles such as goodwill, patents, brands, and know-how are to be measured by their market value (present value) at the end of each financial year. In this case, assets defined literally as the ability to generate future cash flows (“future assets” instead of “past assets”) would be measured by their present value. Evolving against the backdrop of a structural economic shift toward knowledge-intensive industries, this process will feature market valuation of goodwill (including self-established goodwill) and the corporate value as a whole.
As I have thus observed, a proper understanding of what can commonly be called “value-based accounting” would entail not only a discussion of accounting recognition, measurement and presentation, but a consideration of its economic foundations as well.
Economic Foundations of Accounting for Financial
Instruments
The value-based accounting of today is fundamentally different in nature from its 1970s counterpart, price-change accounting, although both purport to employ “market values” of one kind or another. Identifying their difference would serve to highlight the defining characteristics of the present-day form of value-based accounting or fair value accounting. In short, the essential distinction has to do with the difference in the underlying economic foundations of the two types of accounting. What, then, are the economic foundations of today’s fair value accounting focused primarily on financial instruments? And how do they differ from those of price-change accounting? For a genuine understanding of the roots of contemporary fair value accounting, it would be important to place current accounting issues in historical perspective to appreciate the relativity of accounting concepts such as cost allocation, realization, and matching based on economic theory, including a reference to the economic nature of securities and the form of social development of credit systems.
First of all, we must note that the type of capital closely bound with the current problems of fair value accounting for financial instruments/derivatives is fictitious capital, and that its circulation is fundamentally different from that of real capital (functioning capital: industrial capital, commercial capital). In other words, "The nature of fictitious capital lies in its pricing through capitalization: it is completely different from the pricing of commodities. Fictitious capital has its own circulation (M－S－M’) by the conversion of the capital itself into a commodity. This circulation completely differs from M－C－M’ as the metamorphosis of commodities." (Iida[1971]p.125, italics by Ishikawa.)
“Turning now to the peculiar form which the circulation of fictitious capital takes, we find the following: The shares (S) are issued; that is, sold for money (M). One part of this money (m1) constitutes the promoter's circulation in this cycle. The other part (M1) is converted into productive capital and enters the cycle of industrial capital which is already familiar to us. The shares have been sold; if they are to circulate again then additional money (M２) is needed as a medium of circulation. This circulation (S－M２－S) takes place in its own specific market, the stock exchange. Hence, the scheme of circulation in Figure 1. Once a share has been issued it has nothing more to do with the real cycle of the industrial capital which it represents. None of the development or misfortunes which it may encounter in its circulation have any direct effect on the cycle of the productive capital.” (Hilferding[1981] p.113. Italics by Ishikawa. In the above quotation, m1 represents promoter's profit or Gruendergewinn5.)
Figure 1: The
Circulation of Real Capital and Fictitious Capital
M1――
C ―――Ｍｐ …Ｐ …Ｃ１－Ｍ２
Ｓ
Ｌ
ｍ１
Ｍ２
Ｓ
It is important to note here that the circulation of fictitious capital (M—S—M’) represents a separate circulation fundamentally different from the circulation of real capital (M—C—M’) and is “external” to the circulation of real capital, as emphasized in the above quotation that “None of the development or misfortunes……have any direct effect on the cycle of the productive capital.” (see Figure 1).
Whereas the traditional accounting framework with a focus on the concepts of historical cost and realization was essentially designed to capture the circulation of real capital (production and sale of goods and services) by individual capital (the business enterprise), a different accounting framework would be required to capture the circulation of fictitious capital which is fundamentally different from that of real capital. In terms of the economics of finance I have employed here, reason militates against any attempt to address the accounting problems of fictitious capital, i.e., equity securities, by simply extending the accounting framework that was designed to trace the circulation of real capital. Therefore, the “realizability” criterion advocated by the U.S. Financial Accounting Standards Board in its conceptual framework is flawed in the sense that it seeks to merely extend the realization concept originally intended for real goods6 (for a more detailed discussion, see Appendix A).
Let us now further examine current accounting issues by considering what fictitious capital is all about. Uno[1977], for example, elaborated thus:
"In capitalist society a definite series of periodic revenues is capable of identification as a series of interest-payment on a define money-sum of capital; in other words, the periodic revenues are capable of being capitalised by the rate of interest prevailing in the money market, and regarded as interest on the so-called fictitious capital7.”(p.116); “When land is converted into a commodity it obtain a fictitious value, but land is itself a thing or ‘real assets’. But capital is not a thing but a chrematistic operation which is reified and becomes a commodity only by taking the form of a ‘financial assets’ distinct from the real operation of capital itself. Capital in this form of a financial asset is called fictitious capital.” (pp.215-16)
What is vital here is the distinction between real goods in which abstract human labor is objectified and securities (mere pieces of paper) in which no such abstract human labor is objectified8. This distinction has very much to do with accounting. That is to say,
“The market price of securities, which is derived by capitalizing interest and dividend income with the average interest rate, is quite different from the price generally referred to in accounting which is equivalent to the cost-price in economic theory; the economic foundations of these two types of pricing are completely different. While the value (and hence the price) of commodities is formed based on social relations of production (i.e., process of production), the price of securities is formed in the financial markets based on relations of property, i.e., relations based on the ownership of capital. The former is a result of relations of production, but the latter is a result of relations of property (i.e., relations of rights) which are founded on relations of production. Therefore, the principles and patterns of their price fluctuation differ completely. Despite whatever resemblance there may be in their market quotations, they are completely different in nature from the view point of economic theory.” (Kimura[1972] p.260, italics by Ishikawa.)
The central question here is how to solve the problem of accounting for securities in light of the assertion that “the economic foundations of these two types of pricing are completely different,” that “the principles and patterns of their price changes differ completely,” and that “they are completely different in nature from the view point of economic theory.” In broader terms, the question is how to solve the problem of accounting for fictitious capital (not for real capital) as typified by equity securities.
The State of the Art of Fictitious Capital and Its
Implications for Accounting
From the standpoint of economics of finance, the accounting issues for financial instruments/ derivatives are closely related to the present-day development or explosion of fictitious capital. In other words, “The extent of fictitious capital is not fixed. Needless to say, it expands not only quantitatively but also qualitatively along with the accumulation of capital. Intangible property represented by “goodwill” increases together with innovation (patents and introduction of technology) and business combinations. Elsewhere, the development of fictitious capital in both quantitative and qualitative terms is promoted by the formation of idle capital due to the development of the credit system and by legal techniques and institutions which remove or reduce obstacles to the transfer of a right of claim.” (The Institute for Economic Research of Osaka City University[1965] p.161).
The financial derivatives are among the special instruments developed as part of the “legal techniques and institutions” noted above. The contemporary problem of accounting for financial instruments/ derivatives is a consequence of the quantitative and qualitative development of fictitious capital. It also reveals the failure of the traditional accounting framework, essentially designed as a framework for real capital, to adapt to such a development of fictitious capital.
The quantitative and qualitative development of fictitious capital is supported by and closely linked to the system of credit:
“That credit which converts idle money of whatever kind (whether cash or credit money) into active money capital is called capital (or investment) credit, because it is always a transfer of money to those who use it, through the purchase of the various elements of productive capital, as money capital. … As capitalist credit, however, it puts money into circulation only in order to withdraw more money. It puts money into circulation as money capital in order to convert it into productive capital. Thus it expands the scale of production, and this expansion presupposes the expansion of circulation." (Hilferding[1981] p.87.)
The bulk of today’s accounting problems stems not from within productive capital – as in the case of accounting for fixed assets, notably depreciation – but rather from the outside, that is, from the process of transforming idle monetary capital into productive capital, or what is termed “capital credit” in the above citation. For such capital credit to exist, there must be a circulation system which “puts money into circulation only in order to withdraw more money.” And that is precisely what financial instruments such as equity securities are designed to accomplish; to put money into circulation only in order to withdraw more money – a process typified by speculation. While this process is related to extending the function of productive capital (industrial capital), the defining characteristics of today’s accounting issues, viewed from the standpoint of economic theory, lie in the fact that they have emerged, not as a problem directly related to productive capital, but as a problem related to the further development of fictitious capital and of capital credit which serves to support the productive capital.
These considerations based on economic theory are essential if we are to identify the foundations on which today’s accounting issues rest and to derive an insight into the true nature of the problem without confining ourselves to a simple description of existing accounting regulation and practice9.
Distinction Between Accounting for Real Capital and
Accounting for Loan/Fictitious Capital
Differences in terms of the economic nature of capital and the circulation of capital lead to differing concepts of resultant outcomes. Outcomes accrued from loan/fictitious capital (interest, dividends, and capital gains) are totally different in economic terms from outcomes obtained from real capital (operating profit). It is vital to note the differences in the nature of capital behind these outcomes, namely the differences separating operating income on real capital from financial income on loan/fictitious capital. On these differences, Kawai[1960] argued thus:
"Yield or rate of return is a manifestation of interest in higher development which has been stripped of contract factors of interest in the process of social development of the credit system. It is a more void form of interest … for it is a genuine market phenomenon free from all restrictions of contract factors. It is the loan capitalists’ ideal to protect themselves from market risk by relying on interest written into individual contracts as a personal expression of that protection. In the marketplace of capital subrogation, however, the contract factors once so essential for transferring risk onto others simply evaporate and leave the providers of capital exposed to risk.”(pp. 50-51, italics by Ishikawa.)
Since fictitious capital is essentially fictitious loan capital, its outcome undergoes a further transformation from the interest accruing from loan capital to become “a more void form of interest”, “a genuine market phenomenon,” and “exposed to risk.” The derivative instruments we see today were tailored precisely to avert risk in the marketplace in the absence of restrictions of contract factors. As such, they represent further step in the development of fictitious capital.
Since the circulation of interest-bearing loan capital is in itself fundamentally different from that of real capital, and since fictitious capital is essentially fictitious loan capital, the circulation of fictitious capital is further removed from that of real capital10. The existing framework for accounting recognition and measurement, or any simple extension thereof similarly predicated on real capital, cannot be expected to properly measure outcomes from fictitious capital, to the extent that measuring outcomes from fictitious capital, as typified by capital gains and losses (especially unrealized holding gains and losses in terms of the traditional concept of realization)11, qualifies as a form of income determination – instead of being a mere problem of disclosure – set apart from the measurement of outcomes from real capital, and also to the extent that the outcomes from the two types of capital are fundamentally different in terms of their economic substance.
As I have already observed, the underlying economic reality and the object of today’s value-based accounting are, in theoretical or conceptual terms, loan/fictitious capital instead of real capital. This understanding provides the theoretical basis for the important notion that the contemporary value-based accounting for financial instruments is different in nature from the price-change accounting of the 1970s (see Figure 2). It might be worth noting, in this connection, that this is by no means the first time that accounting issues concerning fictitious capital have been raised. Academic accountants in Japan engaged in what is commonly called the “equity premium controversy” in the 1950s, which dealt with the problems of fictitious capital as an issue in accounting for stockholder’s equity, focusing on the credit side of the balance sheet: the securities issuing aspect of the problem. But today, the accounting problem of fictitious capital has reemerged as an issue primarily in accounting for assets, with a focus on the debit side of the balance sheet: the investment aspect of the problem. Figure 2 illustrates this relationship together with accounting for real capital.
Figure 2: Accounting
Problems of Fictitious Capital
Price-Change Accounting (non-monetary assets) in the 1970s －real capital
Assets/
Liabilities Fair Value Accounting (financial instruments) in the 1990s
B/S
－loan/ fictitious capital
Capital － Accounting for Equity Premium in
the 1950s
A theoretical conclusion from the above discussion based on arguments in economics of finance is that income determination involving fluctuating market valuation of financial instruments/derivatives requires an accounting framework separate from the traditional accounting framework (cost-realization framework) of income determination embedded in the real economy.
A Social Science of Contemporary Value-Based Accounting
It has already been three decades since Wasaburo Kimura identified the problem we still confront:
“In accounting,
the problem of valuation of securities has never been resolved indeed even now.
… The price of securities described by the formula, average profit/average rate
of interest, is completely different from
the cost-price of commodities or fixed assets; how to represent it on the
balance sheet has not been resolved. … Accounting has not even begun to address
the problem of valuation of securities. This is a major unresolved issue that
bears on valuation and the nature of price in general.”(Kimura[1972, originally
published in 1961] p.260, italics by Ishikawa)12.
Kimura’s prescience is striking in the present-day context where the problem of value-based accounting for securities and other financial instruments has emerged as a major focus in accounting regulation and accounting theory. It should be noted that his foresight is derived from his research in accounting as a social science13.
Historical considerations and economic analysis figure prominently in studying accounting as a social science. In so doing, the choice of economic theories will assume great importance (see Appendix B). When thus considering the present-day form of value-based accounting, we would need to bear in mind not only the variant forms of value-based accounting, as outlined in Section 2, but to go further back in history to view today’s accounting issues in a longer-term perspective. For a full understanding of the current accounting issues, we would need to identify what prompted the rise of today’s value-based accounting. A useful means to that end would be to employ key concepts in economic theory, notably in economics of finance, to place accounting concepts in perspective. An epitome of this approach may be found in the theoretical distinction between “accounting for real capital” and “accounting for loan/fictitious capital” explained in the preceding section. This distinction could well prove to be a vital means for deciphering the accounting problems of today.
For my purposes here, let me show four key concepts in economics, namely, ①capital, ②income, ③credit, and ④pricing, for example. Note that the italicized parts of Figure 3 correspond to the issues raised in our present-day discussion of value-based accounting, i.e., fair value accounting of Figure 2.
Figure 3: Key
Concepts in Economics
①
Capital: merchant capital,
commercial capital, industrial capital →
loan capital, fictitious capital
②
Income: merchant
profit, commercial profit, industrial profit →
interest, yield(capital
gains)
③
Credit: commercial
credit (distribution credit) → capital credit
④
Pricing: cost-price,
production price → price of fictitious capital
A case in point would be an examination of accounting concepts in light of historical forms of development of the credit system (the distinction between commercial credit and capital credit). From this perspective, it would be problematic to classify securities as a monetary asset14. And as discussed in Section 3, problems inherent in the approach of simply extending the “cost-realization” framework advocated by FASB would become apparent in light of the fundamental distinction of pricing (production-price versus price of fictitious capital) based on the difference of economic foundation[５]. This distinction also implies, as I have noted, that securities prices are based not on “relations of production” of capital but on “relations of property”15. It would follow, therefore, that the contemporary problem of accounting for financial instruments may be characterized as an accounting issue based on “relations of property” of capital instead of “relations of production”16. In terms of individual accounting concepts, the distinction of different economic concepts of capital would prompt a reappraisal of the validity of the categorization of assets in accounting, notably the conventional classification of monetary and non-monetary assets. Similarly, the distinction of different economic concepts of income would invite consideration of the possibility of an alternative concept of income as exemplified by “yield” (capital gains, capital appreciation) which is “a more void form of interest” and “a genuine market phenomenon”(Kawai[1960], as cited in the previous section) different in nature from the traditional concept of realized income. This would in turn lead us to study the possibility of coexistence or hybridization of the two different categories of income.
It is generally recognized that “accounting for fixed assets”, or “depreciation accounting”, that materialized in the 19th Century was an accounting problem prompted by the rise of railroad companies and other forms of industrial capital. In a similar vein, I have noted that the emergence of what may be called “fair value accounting” at the end of the 20th Century has been prompted by the further expansion of loan/fictitious capital. This recent development harbors the possibility of establishing a whole new branch of accounting that may be called “accounting for financial assets (and liabilities),” a field comparable to that of “accounting for fixed assets” or “depreciation accounting.” Whereas fixed assets accounting dealt with problems related to productive capital, financial assets accounting deals with problems related to loan/fictitious capital in the financial economy instead of industrial capital in the real economy. While their manifestations are different, what they have in common is the fact that these branches of accounting are products of dynamic and structural changes in the underlying socio-economic condition and of the evolution of the stock corporation (see Appendix A)17.
Carrying the historical review one step further, an analysis of how the modern stock corporation system has changed since the mid-1980s would seem to provide a clue to investigating current accounting problems, typified by fair value accounting, as a social science. The rise of fair value accounting for financial instruments/ derivatives may be explained by a schematized sequence of events including the “institutionalization” of the securities market since the latter half of the 1980s, which affected the controlling structure of the stock corporation which, in turn, produced consequences for accounting measurement and disclosure. On a more conceptual level, this would call for perspectives of history and economic theory in investigating the problems of accounting measurement and disclosure today, with a reference to the evolution of capitalism from the stage of “separation of ownership and management” (Berle and Means) to that of “managerial capitalism” (Marris) – both arguably commonly recognized phases – and on to the most recent phase of “investor capitalism” (Useem)18.
In this historical and economic study of fair value accounting for financial instruments/derivatives and other contemporary accounting issues such as business combinations and stock options, a key factor would be to examine how present-day accounting practices relates to “(institutional) investor capitalism,” arguably the latest form of capitalist development. International developments, such as the initiatives of the International Accounting Standards Board (IASB) and the G4+1, should be understood not simply as part of the international process of accounting standards harmonization and convergence but also as part of the developmental process of securities markets and of the system of stock corporation. It should be noted that the growing international presence of institutional investors is closely linked to the move towards globalization of accounting regulation and to the impending debate over new accounting standards for business combinations and stock options, for example. The rush toward harmonized and convergent standards in these areas, it is argued, is motivated by a distrust of U.S. standards (which happen to be lax in both of these cases) and a concern for the well-being of institutional investors with internationally diversified portfolios19.
All told, characterizing today’s accounting issues as those of loan/fictitious capital would lay the groundwork for placing individual components such as the equity premium controversy of the 1950s, accounting for real estate and goodwill (both of which have features of fictitious capital), and accounting for financial instruments, in proper perspective. It should then become evident that a major source of difficulty for contemporary accounting regulation and policy concerns loan/fictitious capital which lies at the heart of accounting phenomena today in the place of real capital, and that the manifestations of the accounting problem will no doubt vary in tandem with the sophisticated developing process of loan/fictitious capital.
And finally, it would not be right to conclude this pursuit of a social science of accounting without a reference to the unity of theory and practice. Ultimately, the creation of a comprehensive theory relevant to the synthesis of measurement issues (accounting structure as the computation of capital/income) and disclosure issues (accounting function as regulation and policy) – a major debating point of the JSSSA’s 16th Convention – would contribute to this unity of theory and practice20. And such an undertaking would require an insight drawing not only on accounting but on the economic analyses and historical considerations.
Appendix
A: Requirements for Another Framework of Accounting for Financial Instruments21
1.
Changes in Asset Composition of Manufacturing Firms in the U.S. and Japan
The call for valuation of financial assets at their fair value has gained growing support in the United States since the 1980s and led to the introduction of fair value accounting in the 1990s for marketable securities. Japan has also introduced fair value accounting for trading securities and derivatives beginning with the financial year ended March 31, 2001, and for long-term securities such as cross-held shares beginning with the financial year ending March 31, 2002. In the realm of international accounting standards setting, work is going on to formulate standards providing for across-the-board use of fair value accounting for all financial assets and liabilities held by business enterprises including financial institutions, with the exception of closely held shares lacking marketability. If and when such standards go into effect, not only will typical financial assets such as trading securities and cross-held shares be subject to fair value accounting, but almost all financial assets and liabilities will be accounted for at their fair value, and the resultant gains or losses will find their way into the income statement.
What, then, was the cause behind such a worldwide trend toward fair value accounting? In other words, what were the economic and historical factors behind such a trend? This question must first be answered if we are to develop an adequate understanding of fair value accounting. For my purposes here, let me note the quantitative and qualitative changes in financial assets that accompanied the increased sophistication and diversification of the financial economy.
The share of financial assets as a proportion of total assets has grown significantly in the past three decades. Financial assets, including cash and deposits, trading receivables, and securities, are invariably contractual rights, and are exposed to financial risk involving credit, interest rates, and price changes. These characteristics set financial assets apart from non-financial assets. The ratio of financial assets for investment, such as monetary claims and securities, to total assets has all but constantly grown over the past 30 years among manufacturing firms in both Japan and the United States (see Figure 4). Japanese manufacturers have raised their ratio from approximately 11% at the end of the 1960s up to roughly 26% at the end of the 1990s, while their U.S. counterparts similarly lifted their figures from about 11% at the end of the 1960s to around 44% at the end of the 1990s.
Figure 4: Ratio
of Financial Assets for Investment to Total Assets
of Manufacturing Firms in Japan and the U.S.
(Source: Japanese Ministry of Finance, Financial Statement Statistics of Corporations by Industry and U.S.
Department of Commerce, Quarterly
Financial Report for Manufacturing, Mining and Trade Corporations)
2.
Unique Nature of Financial Assets
Firms typically hold assets with the aim of increasing their corporate value. On this score, there is no difference whether the assets involved are operating assets such as plant and equipment or financial assets such as stocks or bonds issued by private or public sector entities. But an essential difference separates financial assets from operating assets in terms of who creates value and how.
First of all, different actors are involved in value creation. Operating assets are typically deployed in the firm’s operations such as the production and sale of goods and services, and it is the firm itself that creates their value. The value, therefore, will mainly depend on the labor and management abilities available to the firm. Income will be measured by deducting the expired portion of the historical cost of the asset (allocated cost) from realized operating revenues. In other words, the traditional accounting framework based on historical cost and realization holds its own to the extent that operating assets are involved.
In contrast, the value of financial assets is created not by their holder but by their ultimate user. Firms holding financial assets, therefore, need to conduct ex-ante screening and ex-post monitoring of each entity in their portfolios in order to ensure the return of and a return on their investment. Calculating the value of financial assets based on up-to-date information and market prices and conducting their valuation at fair value would enable business managers to keep an accurate tab on their assets and other aspects of their financial position and would also induce them to strive for greater efficiency in investing their assets.
Secondly, operating assets and financial assets involve different processes in creating value. The value of operating assets is created and realized through a firm’s operations, usually its main line of business. In contrast, financial assets have their returns and risks determined by market expectations and macroeconomic trends in the financial markets, factors beyond the control of the firm involved. In comparison to the business risks surrounding operating assets stemming from uncertainties in projected costs and market demand, financial assets are subject to far greater risks of changes in market environment and of moral hazards involving various traders of financial assets.
The value of financial assets, therefore, should basically be determined by capitalizing their expected future cash flows into their present value. And financial assets with high volatility should employ discount rates of interest commensurate with their risk, which would call for a discount rate higher than the measure of capital cost used in investment decisions involving operating assets.
3.
Toward a New Accounting Framework for the 21st Century
Although the use of fair values for the valuation of financial assets has become a predominant trend of our times, there is no definitive theoretical agreement on how to recognize and measure the value of and returns on financial assets which are vastly different from real assets such as merchandise or plant, property and equipment, and how to present them on the balance sheet and income statement.
As I have observed, financial assets are unique in that their market prices are formed as the present value of expected future cash flows, a process inherently different from the pricing process of real, operating assets. Therefore, the valuation and income determination of financial assets cannot be undertaken by a mere extension of the traditional accounting framework but rather require an alternative framework in keeping with their unique mode of pricing, the absence of production cost, and risks inherently different from those of operating assets.
In other words, the present method of income determination based on historical cost and the realization principle is geared to measuring income from activities in the real economy such as the production and sale of goods and services. It is inherently unreasonable to assume that it should also accommodate the measurement of income from activities in the highly sophisticated financial economy of the present day. In this connection, it should be noted that today’s fair value accounting no longer requires traditional income recognition criteria. Direct measurement (fresh-start measurement on market value) at a specific point in time, as typified in the case of current value measurement, is inherently different from the traditional concept of cost allocation. This contrast should be evident from an examination of how to recognize income (gains and losses from changes in market value) from financial instruments such as actual stocks and from derivatives such as futures and options. Thus, income resulting from different kinds of economic activity should be determined based on corresponding frameworks of recognition and measurement. This, in turn, would better serve the financial reporting objective of providing useful information since the information would better reflect the reality of the underlying economic activity.
Whereas the existing income statement merely presents income from financial activity as “non-operating incomes” almost as an afterthought to operating income, it would now be necessary to report income from activities in the financial economy on a more independent basis. Efforts are already under way internationally to explore the possibility of multiple reporting of financial performance based on fundamental differences in economic activity (differences in the source of income) as a future form of financial reporting, suggesting a possible way in which the measurement of income from different types of economic activity may be independently classified and reorganized22. In the context of a pluralization of performance reporting, this points the way toward a "hybrid" system of income recognition/measurement incorporating both the existing framework of historical cost accounting and the emerging framework of fair value accounting for financial assets and liabilities. As such, it would be a combined system of accounting where historical cost accounting and fair value accounting coexist side by side.
On a theoretical level, such an income statement of the future would necessarily call for changes in the categorization or the classification of the elements of the balance sheet as well. Whereas the existing balance sheet depends fundamentally on the criterion of financial liquidity to classify its elements as current or fixed assets/liabilities, it would now be necessary to explore alternative asset/liability categorizations or classifications and corresponding valuation principles based on fundamental differences in economic activity, such as the dichotomy of “non-financial (real) versus financial” or “productive versus non-productive.” In addition, another financial statement dealing with financial flows, the statement of cash flows, should also be taken into account to design a future role for each of the three major financial statements, with the classifications in the income statement and the balance sheet linked to those in the statement of cash flows separating operating, investing, and financing activities from one another. Doing so would more clearly highlight the mutual linkage among the three financial statements and enable their users to obtain an overall picture of business activity in a more integrated form23.
The introduction of fair value accounting for financial instruments/ derivatives today is profoundly related to the quantitative and qualitative changes in financial assets that have taken place over the past three decades of increasing sophistication, diversification, and expansion of the financial economy. As in the 19th Century case of the railroad and other emblems of industrial capitalist development prompting the rise of “fixed assets accounting”(depreciation accounting), the accelerating development of “investor capitalism” since the latter half of the 20th Century is arguably prompting the establishment of a new “financial assets/liabilities accounting” to address financial assets/liabilities which have undergone enormous quantitative and qualitative transformations due to such influences as securitization and the growth of derivatives.
The establishment of a financial assets/liabilities accounting, together with accounting for real estate and goodwill (which have certain similarities with financial instruments) and a new version of accounting adapted to an e-commerce era, which entails a reconstruction of “revenue accounting”, would be essential for building a new accounting framework for the 21st Century. Such a framework should serve to raise the level of transparency and fairness of financial transactions, effectiveness of corporate governance, and efficiency of capital markets.
Appendix
B: A Choice of Economic Theories and Their Perspectives on Accounting24
In order to investigate accounting as a socio-economic phenomenon, our research must draw on economic theory. A major question would be how profound an explanation a chosen economic theory may offer for the essential function of accounting and its dynamism. Hence, the choice of economic theories comes to assume great importance. The following discussion offers a contrast in two types of economic theories and their perspectives on accounting, based on Sunder[1999] and Tsumori[1999].
1.
Two Economic Theories and “Boundary Lines”
According to Sunder[1999], two “boundary lines”, one marking off the separation of ownership and control and the other the subdivision of ownership into a large number of small pieces, serve to separate three different forms of organization which, in turn, correspond to and reflect the classical, stewardship, and market-based perspectives on accounting. Sunder’s second boundary line arguably corresponds with the conflict between and demarcation of “production and real capital” and “credit and fictitious capital”(p.201) noted by Tsumori[1999]. What is noteworthy is that the different perceptions of these boundary lines by the two economic theories, namely the economic theory of organization and the economic theory of capital, are translated into their different perspectives on accounting.
Sunder, for one, offers an explanation for the two boundary lines and the accompanying changes in the forms of organization, but stops short of identifying the intrinsic reasons why the subdivision of ownership occurs at all, a discussion that would correspond to the theory of "mobilization of capital" and "doubling of capital" (Hilferding, 1981, p.128 and p.110) in the context of the economic theory of capital. In other words, the organization theory is short on elaboration of the “logic of development” when compared to the economic theory of capital25. This economic theory perspective, on the other hand, expounds on the logic of development of capital, incorporating such concepts as usurer’s/merchant capital, commercial capital, industrial capital, and finance capital. In view of this perspective, the boundary lines drawn by Sunder need not necessarily be two in number; other lines may be added, for instance, in front of the first line or behind the second. Changes in the forms of business organization may also be explained through this economic theory perspective. A final evaluation of the two theories would seem to rest on which one better illustrates the driving forces behind the dynamism in accounting.
2. A
Contrast in Accounting Perspectives
This contrast becomes increasingly crucial to the perception of accounting since the two economic theories chosen here each find a reflection of themselves in their respective perspectives on accounting. This is a most interesting aspect of the comparison between the two arguments when viewed in terms of the relationship between economics and accounting. Tsumori, for one, describes the conflict of economic foundations astride the “boundary line” (the counterpart of the second line drawn by Sunder) as manifesting itself in accounting as the conflict between “production, real capital, measurement, and the computation of corporate income” and “credit, fictitious capital, disclosure, and income available for dividends”(p.201)26. How Sunder might address this question would be a matter of great interest27.
In accounting terms, the “number and position” of the boundary lines (two, according to Sunder) are to be matched with evolving forms of accounting and accounting perspectives (three, according to Sunder). Thus, each historical stage of development of capital, from that of usurer’s/merchant capital up to that of finance capital, including the present stage marked by increasing sophistication of fictitious capital, comes with a corresponding manifestation of dynamism in accounting and an accompanying array of accounting issues. For instance, the cost allocation-based reasoning underlying the dynamic theory of accounting (as typified by accounting for depreciation) was brought about by the development of industrial capital, notably by the relative expansion of fixed capital. In that sense, the boundary line denoting the emergence of industrial capital is important for accounting theory and practice. In this connection, one might ask how the perspectives offered by the two economic theories would comprehend such manifestations of dynamism in accounting and today’s stage of capitalism which underlies current issues of accounting for financial instruments. Comparing Sunder[1999] with Tsumori[1999] in abstract terms, Sunder may be characterized as underlining commonality and synthesis against Tsumori’s emphasis on transformation and differentiation. In any event, a fascinating contrast is offered by Tsumori and Sunder and the respective economic theories they had chosen, which, in turn, reflect different perspectives on economic and accounting dynamism.
The focus of this author is trained not only on which economic theory to choose from but also on how the different economic theories result in different views of accounting. In my opinion, the two contributions by Sunder and Tsumori warrant comparative scrutiny with special attention devoted to how the differences in economic theory, and hence in the consequent accounting perspective, manifest themselves.
3. “Understanding”
the Dynamism of Accounting
Relating
to the theme of “Economics and Accounting” in Sunder and Yamaji[1999],
this author would like here to take a brief look at some other works which can be classified into three
groups. The first group consists of
market-oriented research based on the neoclassical economic perspective.
Chapter 7 by Gotoh, for example, presents an empirical analysis of the
usefulness of accounting information (financial reporting) for ordinary
investors in the securities market (marketplace for the circulation of
fictitious capital), which is an area of inquiry with a considerable wealth of
research results in terms of analyses of the content and effects of accounting
information. Chapter 9 by Nakano, while similarly market-oriented, breaks new
ground with a model incorporating social responsibility activities by
businesses and their disclosure.
The second group is not market-oriented, but based on the contract or
agency theory perspective. Chapter 4 (in Japanese edition) by Suda28 and Chapter 8 by Okabe, while similarly
empirical in nature like the one by Gotoh, represent empirical research on the
function (namely, function to support inter-firm bonding) of accounting information
not in the stock market but within an inner circle of business partners of a
firm, including what in Japan in commonly called its “main bank.” In economic terms, therefore, this
approach is akin to Sunder’s point about contracts among economic agents. Incidentally, the relationship between
the Japanese “main banks” and accounting information may be viewed, in terms of
the economic theory of capital, as an accounting phenomenon resulting from the
relative dominance of banking capital over industrial capital. The third group,
as mentioned in the previous sections, does not represent positive research,
but dynamic or historical studies on accounting, whose perspectives are based
on the economic theory of organization as in Sunder[1999] and the economic theory
of capital as in Tsumori[1999].
It is interesting to see how different economic theories depict important facets of the same accounting phenomenon or problem differently, albeit with certain overlaps. The notion of “understanding” emphasized in Ijiri[1999] is concerned with developing insights into these differences in accounting perspectives. To illustrate this point, Ijiri discusses the labor theory of value featured in Kimura’s Studies in Accounting. Ijiri then offers an intriguing methodological comparison of Sanders, Hatfield and Moore’s A Statement of Accounting Principles (designated as Level 1), Paton and Littleton’s An Introduction to Corporate Accounting Standards (Level 2), and Kimura’s Studies in Accounting (Level 3). That comparison is quite interesting especially from the viewpoint of the role of accounting theory. We can also compare the first and the second groups described above with the third group by using this conception of “understanding” as a “supertheory.”
The choice of economic theories as the foundation for accounting research is crucial for developing a social science of accounting. A major criterion in that selection process is how profound an understanding or insight of the various accounting developments may be obtained. We would do well to heed Ijiri’s cautionary remark that “engaging in explanations, predictions, and actions without understanding carries a great risk. …Without understanding of the big picture, behavior is driven by the accident of detail, and success, if achieved, proves to be transient.” (p.188) From this viewpoint, Ijiri offers praise for Kimura’s Studies in Accounting, saying “it makes a great deal of sense as a supertheory; true understanding of accounting requires trying it to other fundamental disciplines.” (p.189).
Today, the bulk of research done in accounting, particularly in North America, falls in the area of applied research. In contrast, foundational studies in accounting are not held in such high esteem and not as vibrant as it might be29. Such a state of affairs would seem to call for a renewed emphasis on the importance of foundational studies in accounting today. The theoretical discussions in this paper, in which today’s accounting issues such as fair value accounting for financial instruments are traced to the increasingly sophisticated fictitious capitalization as distinguished from real capital, represent an attempt to demonstrate the role of accounting theory in providing the much-needed “understanding” of the origins and nature of the major accounting issues of our time.
Acknowledgements
I express my
appreciation to Yoichi Hara (Ritsumeikan University) for his great contribution
of the translation, while assuming full responsibility for whatever errors that
might remain rests upon myself.