In the real world, debits don’t equal credits, by Ronald J. Baker

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A lot of rules have been added since the Venetian monk Luca Pacioli published the first accounting textbook in 1494, introducing double-entry bookkeeping.

Unfortunately, one could also make the argument that it was the last revolutionary idea to come from the accounting profession.

The balance sheet dates from 1868; the income statement from before World War II. Generally Accepted Accounting Principles (GAAP) fits an industrial enterprise, not an intellectual one. Currently, GAAP measures the cost of everything, and knows the value of nothing.

Even though intellectual capital is the main driver of wealth, you will look in vain to find them in the traditional GAAP statements. Increasingly, these statements are being referred to as the "three blind mice."

According to Dr. Margaret Blair, in a study for the Brookings Institution, in 1978, 80 percent of a company's value could be attributed to its tangible assets. By 1988, only 45 percent; in 1998, only 30 percent. In effect, 70 percent of the average company's value cannot be explained by traditional GAAP financial statements.

Adding more arcane and picayune rules to GAAP, or converging existing GAAP with international accounting standards, will not solve this problem. The accounting model is suffering from what philosophers call a deteriorating paradigm - the theory gets more and more complex to account for its lack of explanatory power.

Financial Model Reform

We are asking far too much of accounting if we expect it to be able to do anything other than record historical transactions. To peer into the future requires a theory. The accounting profession simply does not possess the intellectual capital to posit and test theories.

Enron and the other spate of accounting scandals from the early 2000s were not so much about fraud, malfeasance, misfeasance, or other crimes, but rather the increasing irrelevance of the traditional accounting reporting model. Enron's legerdemain is not what caused it to fail. Its financial deception allowed it to remain in business for longer than an otherwise similar firm engaged in accurate financial disclosures, but this is a question of timing alone and not causality.

I see three possible roads for the accounting profession to travel into the future. On the first, it can do nothing, which is usually the road traveled most by stagnating industries. No doubt the profession would survive in some shape, since a lot of its work is governmentally mandated, but it will relinquish its status as the premier financial profession if it chooses this path.

On the second road, outsiders could replace the profession, the "perennial gale of creative destruction" Joseph Schumpeter wrote about. Accountants would go the way of the scribes.

Finally, on the third road, the profession could innovate and become its own creative destroyers. Why not relinquish its monopoly on offering auditing services, opening up the field to competition from banks, insurance companies, and any other industry that wanted to attest to financial statements? Why should the audit be a state-granted monopoly? Open it up and let the free market innovate new solutions to attesting to the financial performance and risk position of companies.

Insurance companies and banks could innovate new products, the stock markets could also enter the fray, perhaps by hiring the auditors themselves and thereby remove the major conflict of interest - the fact that auditors are paid by the very companies they are supposedly auditing. Sarbanes-Oxley did nothing to deal with this conflict.

The accounting profession has a choice: adapt to the realities of an intellectual capital economy, or slide further into irrelevance.

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About the author
Ron Baker is the best-selling author of "The Firm of the Future: A Guide for Accountants, Lawyers, and Other Professional Services;" "Pricing on Purpose: Creating and Capturing Value;" "Measure What Matters to Customers: Using Key Predictive Indicators;" and "Mind Over Matter: Why Intellectual Capital is the Chief Source of Wealth," from which this article has been adapted. You can reach him at (707) 769-0965, or e-mail at [email protected]. He Blogs at Copyright © 2007 Ronald J. Baker. All Rights Reserved.

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