Holiday Inn Case Seeds
Two Ideas for Hotel Replacement Cost Cases in Accounting

Bob Jensen at Trinity University 

One of the most popular Excel spreadsheets that Bob Jensen ever provided to his students ---
www.cs.trinity.edu/~rjensen/Excel/wtdcase2a.xls

·     Conforms to capital maintenance theory that argues in favor of matching current revenues with what the current costs are of generating those revenues. For example, if historical cost depreciation is $100 and current cost depreciation is $120, current cost theory argues that an excess of $20 may be wrongly classified as profit and distributed as a dividend. When it comes time to replace the asset, the firm may have mistakenly eaten its seed corn.

 

·     If the accurate replacement cost is known and can be matched with current selling prices, the problems of finding indices for price level adjustments are avoided.

 

·     Avoids to some extent booking the spread between selling price and the wholesale "cost" of an item. Recording a securities “inventory” or any other inventory at exit values rather than entry values tends to book unrealized sales profits before they’re actually earned. There may also be considerably variability in exit values vis-à-vis replacement costs.
 

Although I am not in general a current cost (replacement cost, entry-value) advocate, I think you and Tom are missing the main theory behind the passage of the now defunct FAS 33 that leaned toward replacement cost valuation as opposed to exit valuation.

The best illustration in favor of replacement cost accounting is the infamous Blue Book used by automobile and truck dealers that lists composite wholesale trading for each make and model of vehicle in recent years. The Blue Book illustration is relevant with respect to business equipment currently in use in a company since virtually all that equipment is now in the “used” category, although most of it will not have a complete Blue Book per se.

The theory of Blue Book pricing in accounting is that each used vehicle is unique to a point that exit valuation in particular instances is very difficult since no two used vehicles have the same exit value in a particular instances. But the Blue Book is a market-composite hundreds of dealer transactions of each make and model in recent months and years on the wholesale market.

Hence I don’t have any idea about what my 1999 Jeep Cherokee in particular is worth, and any exit value estimate of my vehicle is pretty much a wild guess relative to what it most likely would cost me to replace it with another 1999 Jeep Cherokee from a random sample selection among 2,000 Jeep dealers across the United States. I merely have to look up the Blue Book price and then estimate what the dealer charges as a mark up if I want to replace my 1999 Jeep Cherokee.

Since Blue Book pricing is based upon actual trades that take place, it’s far more reliable than exit value sticker prices of vehicles in the sales lots.

 Conclusion
It is sometimes the replacement market of actual transactions that makes a Blue Book composite replacement cost more reliable than an exit value estimate of what I will pay for a particular car from a particular dealer at retail. Of course this argument is not as crucial to financial assets and liabilities that are not as unique as a particular used vehicle. Replacement cost valuation for accounting becomes more defensible for non-financial assets.

·     Discovery of accurate replacement costs is virtually impossible in times of changing technologies and newer production alternatives.  For example, some companies are using data processing hardware and software that no longer can be purchased or would never be purchased even if it was available due to changes in technology. Some companies are using buildings that may not be necessary as production becomes more outsourced and sales move to the Internet. It is possible to replace used assets with used assets rather than new assets. Must current costs rely only upon prices of new assets?

 

·     Discovering current costs is prohibitively costly if firms have to repeatedly find current replacement prices on thousands or millions of items.

 

·     Accurate derivation of replacement cost is very difficult for items having high variations in quality. For example, some ten-year old trucks have much higher used prices than other used trucks of the same type and vintage. Comparisons with new trucks is very difficult since new trucks have new features, different expected economic lives, warranties, financing options, and other differences that make comparisons extremely complex and tedious. In many cases, items are bought in basket purchases that cover warranties, insurance, buy-back options, maintenance agreements, etc. Allocating the "cost" to particular components may be quite arbitrary.
 

·     Use of "sector" price indices as surrogates compounds the price-index problem of general price-level adjustments. For example, if a "transportation" price index is used to estimate replacement cost, what constitutes a "transportation" price index? Are such indices available and are they meaningful for the purpose at hand? When FAS 33 was rescinded in 1986, one of the major reasons was the error and confusion of using sector indices as surrogates for actual replacement costs.

 

·     Current costs tend to give rise to recognition of holding gains and losses not yet realized.
 
 

Tom Selling and I have been having a bit of a go around recently (actually dating back several years) over the benefits of replacement cost accounting as a substitute of historical cost accounting of operating assets (land, buildings, machinery, vehicles, etc.).

I have two starting modules on this topic at the following links:
http://www.trinity.edu/rjensen/Theory02.htm#FairValue  (in particular scroll down to Days Inn and U.S. Steel)
http://www.trinity.edu/rjensen/Theory02.htm#BasesAccounting

Tom has two starting modules on this topic at the following links:
Click Here and Scroll Down
http://accountingonion.typepad.com/theaccountingonion/2011/12/im-for-auditor-term-limits-but.html

or Click Here
http://accountingonion.typepad.com/theaccountingonion/2012/01/its-nice-to-win-something-even-if-its-the-losing-cause-man-of-the-year.html

There are three basic issues. One is whether replacement costs should literally replace historical cost (traditional) accounting of most operating assets in single-column financial statements. The second issue is whether replacement cost financial statements should be required as supplementary financial statements as they were under FAS 33 before it was rescinded. The third issue and related issue is whether benefits versus costs of generating verifiable replacement cost numbers are such that the benefits are deemed much greater or lower than the cost.

The first thing to note is that replacement cost accounting is not valuation accounting. The current book value of a building after 40 years of straight line depreciation may be $10 million. The replacement cost may be $120 million today, but the replacement cost book value my only be $40 million after depreciating the current replacement cost. The exit value of the old building today be negative since buyers of the site and building only want the land and would tear down the old building.

The second thing to note is that the cost of generating verifiable replacement cost numbers for operating assets can be very costly. One reason is that many of the most expensive assets like factory buildings, warehouses, stores, hotels, etc. are highly unique. Whereas it's quite easy to derive the verifiable current replacement cost 500 shares of IBM common shares because these shares are fungible items, the cost of generating verifiable replacement cost numbers for each of 500 Holiday Inn hotels is very expensive since each one varies in location, size, and local construction codes and costs such as the difference between construction codes and labor costs in Manhattan versus a hurricane alley in Biloxi.

Today on Friday the 13th (January 13, 2012) Erika and I returned from staying one night in the Holiday Inn in downtown Concord, NH. and a second night in the relatively new Marriott Courtyard in Concord.

It dawned on me that  it might be informative if some accounting researcher (not me) wrote a case about two old and rather shabby Holiday Inn hotels where I've stayed at recently. One might might be described shabby and possibly uncomfortable. The other might be described as really shabby and most likely very uncomfortable. I say this noting that I am a Holiday Inn Priority Club loyalist and frequently seek out Holiday Inn hotels, because they are usually be best value for the money in terms of location and price. Quality is variable among Holiday Inns, and location often trumps both price and quality in some instances, especially the shabby Brookline Holiday Inn that we stay in frequently that's close to the Harvard Medical School where Erika has repeated medical services from her wonderful nearby spine surgeon.

Before I describe these two shabby Holiday Inn hotels, I suggest that these would make wonderful cases for studying how replacement cost accounting alone can be very misleading. Hence I will concentrate on the benefits (positive and negative) of replacement cost accounting apart from the cost of generating verifiable replacement cost data (which would entail input from (often flakey) real estate appraisers and architects) in the case of hotels.

Historical Cost Hypothetical Data for the past year (2011)
Consider first the Holiday Inn in Concord, NH. Based upon my hypothetical data, the book values 2011 daily revenues and book values are as follows:
$150 plus free parking per night per room average after factoring in an 80% occupancy rate in 2011
$60 per night net positive cash flow after deducting all cash costs for labor, utilities, taxes, and daily maintenance of all occupied rooms
$50 per night historical accrual net profit after deducting for room depreciation (for infrequent new carpets, curtains, paint, mattresses, and furnishings including TV sets). Since the rooms in this hotel are shabby and most of the window air conditioners will not allow for varying temperature settings, I conclude that the rooms are upgraded very, very infrequently in this particular old hotel).
$50 per night net profit after deducting for building depreciation since this old building is most likely fully depreciated but still in solid condition.

Replacement Cost Hypothetical Replacement Cost Data for the past year (2011)
$150 plus free parking per night on average after factoring in an 80% occupancy rate in 2011
$60 per night net positive cash flow after deducting all cash costs for labor, utilities, taxes, and daily maintenance of all occupied rooms
$60 per night accrual net profit after deducting for room replacement cost depreciation (for infrequent new carpets, curtains, paint, mattresses, and furnishings including TV sets). Since the rooms in this hotel are shabby and most of the window air conditioners will not allow for varying temperature settings, I conclude that the rooms are upgraded very, very infrequently in this particular old hotel).
-$100 per night negative profit per room after deducting building replacement cost depreciation

Of course the hotel's building was actually replaced, we would expect room rates to be increased. But since Tom is talking about replacement costs of historical revenues, it would be pure fiction to adjust replacement cost financial statements for past earned revenues.

Especially note that 2011 replacement cost financial statements are not very good estimates of future financial statements since many things would change if the Concord, NH Holiday Inn building was actually replaced. Firstly, the 2011 room pricing would most likely be increased as much as possible to recover the replacement costs and still earn a profit. Secondly, there would be many innovations such solar panels or other more efficient attributes of modern building operation and maintenance. In Concord, NH property taxes would jump enormously for a new building since Concord has the highest property tax rates in New Hampshire.

It is also uncertain what Tom means by "replacement." In the case of the Holiday Inn in Concord, NH there are two viable and highly different "replacement" alternatives. One replacement alternative would be to virtually gut the lobby, restaurant, and all the rooms but replace everything within the old building. The other replacement alternative would be to tear down the old building and replace it with a new and much different building.

What replacement alternative did you have in mind Tom if you were to generate Year 2011 replacement cost financial statements for this old Concord, NH Holiday Inn? Should replacement costs be based upon a gutted old building or an entirely new building?

Now when it comes to the Holiday Inn in Brookline, MA gutting the old building and putting new rooms in the old building is probably not a viable option that should be considered. The reason is that this old hotel building is so poorly designed and wastes so much space that the only viable replacement alternative would be to build a new building.

My Major Point
My major point is that replacement cost financial statements of the Holiday Inns in Brookline, MA and Concord, NH are probably more misleading than helpful if they are not accompanied by general price-level adjusted historical cost financial statements over the years 2000-2020. The reason is that by Year 2000 the buildings most likely were fully depreciated without any intent to replace them during those years or in the next decade or more. Replacement cost adjustments are pure fantasy and probably more misleading than beneficial until replacement itself is on the table..

The same reasoning applies to aging rooms of Holiday Inns that are in major airport hotels. Passengers seeking short stays in airport hotels are most likely not willing to pay $100 more per night for a glitzy room in a Airport Holiday Inn if the Airport Days Inn hotel across the street is a better buy for the money and has identical airport shuttle services.

These old buildings with convenient locations are tremendous cash cows for Holiday Inn or other owners and probably turned out to be better investments per room than most any other newer Holiday Inn hotels. The reason is location, location, and location when coupled with price elasticity of room rates in these particular locations. Each of these Concord, Brookline, and airport hotels serves a unique type of customer that will not pay $100 more per night to stay in a nicer room or eat in a nicer restaurant in these particular locations. The story might well be different for Holiday Inns in downtown Manhattan, Miami, and San Francisco where customers might willingly pay $100 more per night for a more glitzy room with a view. But who cares about glitz and the view in downtown Concord or Brookline?

If some case writer is willing to take up my challenge to write up a case about the Concord, NH Holiday Inn, here are some facts of possible interest.

1. This Concord Holiday Inn is in a relatively old by solid building with location, location, location. It's a block from I-93 ramps. It's on the end of the main downtown street in Concord (downtown is only about four blocks long). Most importantly it's only a few short blocks from the gold-domed NH State Capitol building and surrounding state offices and courtrooms.

2. Concord is a very small city/town with relatively poor taxi service, especially in rush hours. Parking is very tight around the State Capitol, so there's a huge monopoly advantage of location for the nearby walking-distant Holiday Inn. Anybody doing business in the State Capitol area will soon discover this main advantage of the nearby Holiday Inn is that has no other walking-distance competition  If this same Holiday Inn building was located two miles away it might only be able to charge half as much for its old shabby rooms. Replacement may then be on the table.

3. One of the huge discomforts of the Concord Holiday Inn is the window air conditioning. When we checked in to Room 205 in this Concord Holiday Inn  three  days ago the air conditioner did not work at all. When we were moved to Room 206 the air conditioner would only put out a trickle of heat not suited to the 20F temperature outdoors and a brewing blizzard. When we were next moved to Room 210 where we had heat for the night but the window air conditioner only worked on high and was not controllable with a thermostat. So every two hours during the night I turned the heat on and off so as not to cook or freeze during the entire night. Since we were not in this hotel for business at the State Capitol, we moved out to another hotel the next day. Location was not so important to us, and Holiday Inn really disappointed us in Concord, NH. Fortunately when we checked in at noon there were some other vacant rooms to try out for heat. I don't know how the guests managed if they checked in late in the day and were assigned to rooms with poor heaters.

4. The carpets were so grimy in each of those rooms that we did not even want our socks to touch the floor.

5. The curtains were so dirty that if you slapped at them you could literally see the dust fly.

6. Around the bath tub the caulking looked like frayed, cracked, and mildewed hemp rope.

7. But this hotel was fully occupied as it is on most nights. I don't think the hotel cared when we checked out a day early. There were people in line waiting eagerly for our old shabby room. They most likely had business in downtown Concord or in the State Capitol area.

8. If I had millions of dollars and wanted to buy a profitable cash cow hotel, I would probably first consider the old Concord Holiday Inn even if the 2011 replacement cost financial statements made it look like a horrible investment.

If some case writer is willing to take up my challenge to write up a case about the Brookline Holiday Inn, here are some facts of possible interest. For all practical purposes Brookline is a nice area of Boston, and there really is no way of knowing when you drive from Boston into Brookline.

1. This Brookline Holiday Inn is in a relatively old and weird building with location, location, location. It's within walking distance of some of the restaurants and shops, but this is not a noted part of Boston for tourists But more importantly, the Brookline Holiday Inn is undoubtedly the main hotel serving the nearby Harvard University Medical Center and ten or more major hospitals, medical service centers, and offices of hundreds of the best physicians in the United States.

One of the most disappointing things to Erika and me about this HUMC (Longwood) area is the shortage of hotels. I cannot imagine why other hotel chains do not build in this medical center area to serve this enormous medical complex --- except for one possible reason that the Brookline Holiday Inn has 300 reasonably-priced rooms (relative to many Boston-area hotel prices).

2. Boston is a huge city with great taxi service, but the streets are poorly laid out and traffic jams caused by perpetual street construction are legendary. Hence, there are serious drawbacks of not staying in either the Brookline Marriott Courtyard or Holiday Inn in Brookline. The Marriott Courtyard is a newer glitzy hotel that charges about $130 more per night with no medical discounts plus $30 for basement parking. The Holiday Inn has medical discounts plus parking is only $15 per night in the basement. With a medical discount the room rates are currently around $150 per night (slightly more in the so-called "tower").

3. I suspect that by now the 300-room Brookline Holiday Inn is fully depreciated for accounting purposes. It's a weird building today. Around 1950 it was a huge and traditional Holiday Inn Motel that was two stories in a rectangular shape with an inner outdoor courtyard for a pool and lounge area. The far end of the motel was nearly a block from the lobby. Then perhaps 50 or more years ago, a small tower was built over the lobby attached to a brick and glass shell that now surrounds the old motel. The tower has six stories and central heating/cooling, but it's so small that it only has one elevator. The huge "atrium" part of this Holiday Inn is really just the old motel with its hundreds of clanking (now "indoor") window air conditioners and the old swimming pool (now inside the big shell.)

4. The carpets are so grimy in each of those rooms that we do not even want our socks to touch the floor.

5. The curtains are so dirty that if you slap at them you can literally see the dust fly.

6. Around the bath tub the caulking looks like frayed, cracked, and mildewed hemp rope.

7. But this hotel is 80% occupied on most nights and fully occupied on event nights in the Boston area such as Red Sox games and nearby Boston University graduations and alumni events. The steady customers come in two varieties. Some are "doing business" with the many nearby hospitals and the Harvard University Medical Center itself. For example, it's very common to ride the shuttle van to the hospitals with medical school graduates from all over the world who are now seeking residency training in this area. The second variety of Holiday Inn guests are old folks like us with appointments in the hospitals and many offices of physicians in the area.

8. If I had millions of dollars and wanted to buy a profitable cash cow hotel, I would probably consider the old Brookline Holiday Inn even if the 2011 replacement cost financial statements made it look like a horrible investment.

9. If a hotel chain like Hilton or Sheraton built a towering hotel in Brookline, the room prices would probably have to be so high that the Brookline Holiday Inn with its 300 rooms would still thrive because of lower prices. Guests just do not come to Brookline for the Boston Pops, theatres, skiing, conventions, or the ocean beaches. The bigger and better hotels are located closer to downtown Boston.

What I really would like to see is for a diligent case researcher to dig out the true financial and marketing data for both the Concord and Brookline Holiday Inn hotels. Case writers usually are skillful about disguising true hotel names and locations if the owners do not want to be associated with the case writeups. The Brookline Holiday Inn actually is not owned by Holiday Inn even though it is a Holiday Inn. About two years ago it was purchased by new owners who spent quite a lot of money on the lobby area and putting new carpets in the hallways. Not much has changed in the rooms as far as I can tell.

The new owners have not yet been able to make the restaurant pay. It is huge and closed every noon and night. Guests can eat hamburgers and finger foods in the bar, but the bar is never busy since old folks going to hospitals are not good bar customers. These folks are most apt to eat in the excellent hospital cafeterias before returning to their hotel. The bar has one bartender and no table servers other than the bar tender.

I don't know anything about the Concord Holiday Inn ownership.

If I were CEO of Holiday Inn I would want the particular Holiday Inns in Concord and Brookline upgraded to at least what one expects in the way of cleanliness, appearance, and air conditioning in any Holiday Inn hotel. But I would not expect much since these hotels are cash cows without having to invest a whole lot more in plant.

My Main Concluding Point
My major point is that replacement cost financial statements of the Holiday Inns in Brookline, MA and Concord, NH are probably more misleading than helpful if they are not accompanied by general price-level adjusted historical cost financial statements over the years 2000-2020. Replacement cost accounting statements would've made the 2011 financial performances of these hotels look too gloomy. The main reason is that thus far in the 21st Century  the buildings most likely are fully depreciated without any intent to replace them in decades to come. Replacement cost adjustments are pure fantasy and probably more misleading than beneficial until replacement itself is on the table. Why should replacement be on the table since these fully depreciated buildings remain such huge cash cows in markets that are very price elastic?

These old buildings with convenient locations are tremendous cash cows for Holiday Inn owners and probably turned out to be better investments per room than most any other newer Holiday Inn hotels. The reason is location, location, and location when coupled with price elasticity of room rates in these particular locations. Each of these Concord, Brookline, and airport hotels serves a unique type of customer that will not pay $100 more per night to stay in a nicer room or eat in a nicer restaurant in these particular locations. The story might well be different for Holiday Inns in downtown Manhattan, Miami, and San Francisco where customers might willingly pay $100 more per night for a more glitzy room with a view. But who cares about glitz and the view in downtown Concord or Brookline?

The aging Holiday Inn hotels in Concord, NH and Brookline, MA have not been replaced in the 21st century and most likely will not be replaced tor 20 or more years even though rooms will be refurbished on some cycle like every 10 years. Rates will remain relatively high for these old hotel rooms and yearly occupancy will remain high. However, the rates are not so high as to attract bigger and more expensive hotels to be built on nearby sites. This is in large part due to the price competition of these older Holiday Inns that will attract a particular type of clientele that is more price conscious than vacationers in Manhattan, Biloxi, or San Francisco.

Replacement Cost accounting may be more suited to a Holiday Inn on Miami Beach than it is for downtown Concord, NH or Brookline, MA.

January 14, 2012 reply from Tom Selling

Bob,

 

I am actually in the middle of writing a replacement cost-themed blog post, which I hope to have completed by Monday at the latest.  I think this will answer some of your questions.  As to the question of how replacement cost numbers would be used by investors, I do have three quick responses:

 

·         Replacement costs are an input to the calculation of Tobin’s Q, which is a tool used by financial analysts – even though the accounting data available is a very unreliable surrogate for replacement costs.

·         Replacement costs measure the amount of wealth invested in assets, and form the foundation for determining what an adequate return on investment should be. With historic cost accounting, one doesn’t have a clue as to the amount of wealth invested for which a return is to be expected.

·         This is undeveloped at this point, but I may soon be writing a blog post on replacement costs and LBOs. The motivation is in large part due to the criticisms (justified or not) of how Romney made his fortune.   When Mitt Romney is being criticized for being a “vulture”, the public doesn’t realize that at least part of the motivation for an LBO transaction in which the company is taken private is the available accounting treatment.  One important factor is that the acquirer may be able to avoid recording a new basis for the assets “acquired” in the LBO.  As a result, the going public prospectus will understate depreciation and show inflated measures of profitability and ROA.  Assuming for the moment that this was the only basis for the transaction, then LBO activity is obviously inefficient to society as a whole – even though Bain Capital may have generated a high return for itself by “churning” the company – and wreaking havoc in the process.  Again, this is an undeveloped point.

 

Finally, I will give you an example similar to your hotels, but more personal and one that my wife and I was just talking about today.  We have a condo in Hanover NH that we rent to Dartmouth students.  It has been rented 100% of the time, and we increase the rent each year like clockwork.  In short, it’s a cash cow.  I purchased it 25 years ago, so its book value is close to zero.  Also, because of its age and some other unique factors we couldn’t sell it for anywhere near the present value of the future expected cash flows – even though I might like to sell it at this point in our lives.

 

How would I measure this condo on our personal balance sheet?  I would say that the most appropriate way would be to determine how much it would cost me to replace the expected future cash flows.  But, I AGREE WITH YOU that this would be very subjective and perhaps even costly to undertake.  As an accounting policy, in such a case, I believe the utility of the condo might be reasonably (although pretty conservatively) measured by the amount we could sell it for.  Although not identical, this is pretty consistent with the “ceiling” limitation on the ARB 43 “market” measurement for inventories, which has stood the test of time (60 years, maybe) better than any other accounting standard I can think of. 

 

In the case of your hotels, I would add that there are plenty of brokers that list all sorts of run down properties similar to the hotels you stayed at.  Location may be important to you, but to investors, it’s the cash flows that really count.  I suppose that location may be unique for some small set of assets that are highly integrated with other assets, but that’s more a question of the unit of account – which is a problem no matter which basis of measurement one uses.

 

By the way, Bob, I’m writing this from your old stomping grounds – San Antonio.  We’re here to watch our son play basketball for Trinity U – and I’ll be meeting Walter Schuetze for lunch tomorrow. 

 Best,

Tom

January 14, 2012 reply from Bob Jensen

Hi Tom,

The real problem is that 2011 replacement costs financial statements are mixing 2011 realized revenues with future replacement investments that, among other things, will have future incremental revenues not factored into realized 2011 revenues. These are not 2011 proforma statements using forecast revenues from replacement assets. These are 2011 realized revenues generated from the old operating assets.

You're still missing my point about replacement cost 2011 financial statements for the Concord Holiday Inn. Mixing 2011 earned revenues with the depreciated cost of a new hotel that's not even being contemplated seems to me to be a bad case of mixing realized revenues with a totally fictional building investment.

I just don't see how 2011 replacement cost financial statements would be be of great interest to investors in shares of this hotel's ownership. The investors might be interested in pro forma statements based upon future cash flow streams for various alternative new hotel replacements, but this is not the same as 2011 replacement cost financial statements on the old hotel building.

As far as Tobin's Q goes for Holiday Inns, it would be interesting to see if analysts have ever tried to use this ratio for evaluating past performance of hotels. My guess is that it would be very hard to find a hotel investment analyst who puts much stock in Tobin's Q. Hotel analysts will look to past traditional financial statements of a hotel to see how well management of that hotel managed past invested capital and will estimate future cash flow streams under various configurations of new investments, new management, and shifts in market conditions (such as new hotel construction by competitors in the vicinity).

But I am impressed that you are indeed attempting to show both me and hotel investment analysts how they've been missing the boat by not using Tobin's Q. There might be great consulting opportunities for you here if you can show them how Tobin's Q can benefit them more than the traditional ways they evaluate past performance of a hotel and future prospects for that hotel if it is replaced.

The real problem as I see it is that future replacement costs need to be matched with estimated future revenues. That makes sense, but matching past revenues with future investments makes little sense and is limited to the extent that past revenues are predictive of future revenues. In the case of hotel replacement, however, hotel pricing is likely to change in order cover new invested money.

My Major Point A new hotel might also attract new types revenues. For example, neither the Concord Holiday Inn nor Brookline Holiday Inn hotel makes much money from their lousy and tiny meeting rooms. Replacement hotels might contain better meeting rooms that attract mini-conferences and local events. This reinforces my contention that future replacements need to be matched with future revenues rather than past realized revenues. This could complicate Tobin's Q analysis since current revenues in the numerator do not contain incremental new meeting room revenues of the future if the replacements are actually made in the future.

But I'm really looking forward to a Tobin Q analysis of the Holiday Inns in Concord and Brookline where there seems to be little incentive to replace highly successful older hotels rolling in the cash.

One possible research project might be to interview and or survey financial analysts in general to see why and how they use in Tobin's Q. You may be assuming too much about the value of Tobin's Q in portfolio decision making.

One added note Tom.
An alternative definition of Tobin's Q is as follows:
 

Definition of 'Q Ratio (Tobin's Q Ratio)'

A ratio devised by James Tobin of Yale University, Nobel laureate in economics, who hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm's assets:

 

                                        Total Value of the Firm
Tobin's Q =          -----------------------------------------------
                            Replacement Value (Cost) of the Firm's Assets

Read more: http://www.investopedia.com/terms/q/qratio.asp#ixzz1jTDwJeuU

 

To me this is a very troublesome definition. Besides the usual problems of measuring the value of the firm (the numerator) in practice, there's the issue of that that value is affected by virtually everything in the world concerning a firm, including such factors as changes in competition, changes in the supply chain, changes in national and world events, etc.

And the there's the intractable problem of computing the replacement cost of the "firm's assets" in the denominator. One huge stumbling block is that accountants usually partition "assets" into those that are booked versus those that are unbooked in the ledger. Unbooked assets include many intangibles such as the value of the firm's human resources, the value of its trademarks and reputation, and on and on and on. How do we compute the replacement value of the human resources and reputation of Apple Corporation?

Certainly scholars in the accounting academy who have written about replacement cost accounting never envisioned the components of Tobin's Q. Virtually all those scholars limited the scope of replacement cost accounting to converting booked historical cost (or possibly exit values) of booked assets into replacement costs. Thus, previous replacement cost accounting scholars really have not, to my knowledge, written anything practical about adding the other components to Tobin's Q.

I suggest that you, Tom, confine your analysis of replacement cost accounting to only comparisons of traditional versus replacement cost financial statements containing only items booked in the ledger. I is entirely impractical to suggest deriving replacement costs of all of a firm's unbooked assets.

Thanks,
Bob

 

January 17, 2012 Update

Tom Selling has what I consider to be a much more reasonable posting on replacement costing:
"What I Mean by "Replacement Cost" is not Literally Replacement Cost," by Tom Selling, The Accounting Onion, January 17, 2012 --- Click Here
http://accountingonion.typepad.com/theaccountingonion/2012/01/what-i-mean-by-replacement-cost-is-not-literally-replacement-cost.html?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+typepad%2Ftheaccountingonion+%28The+Accounting+Onion%29

Jensen Comment
His latest posting remains, however, disappointing to me in that he does not delve into how traditional replacement (current) cost accounting of operating assets like factories, stores, hotels, airliners, can be more misleading than helpful if it is not accompanied by traditional historical cost financial statements and possibly exit value statements (although exit value is not very relevant for going concerns with lots of synergy covariances of asset values "in use."

Some of his statements do not adequately stress that replacement cost accounting is not value accounting since it has identical accrual issues of depreciation, depletion, amortization, bad debt estimation, etc. that plagues historical cost accounting. For example, he states:

"First, replacement cost measures are the only possible way for accounting to reflect wealth invested by shareholders in an enterprise; and consequently, changes in invested wealth."
Tom Selling as cited above

Firstly, I almost always advise against sweeping generalization such as the "only possible way to reflect wealth invested by shareholders ..."
Such sweeping generalizations should be avoided in the Academy, especially when when our accounting history research literature is brimming articles from scholars who do not share Tom's view about replacement cost accounting (even in theory). Kenneth McNeal would not call replacement cost accounting "Truth in Accounting" or even being the best of asset measurement alternatives ---
http://www.trinity.edu/rjensen/Theory02.htm#BasesAccounting

Secondly, he still is speaking of "flowers in spring" to Julie Andrews without giving her the "show me" she's demanding. He still has not made a convincing case on how even his hybrid version of replacement cost accounting would be relevant to my two Holiday Inn case seeds at
http://www.cs.trinity.edu/~rjensen/temp/HolidayInnCaseSeeds.htm

To his credit, in his latest posting Tom does not mention Tobin's Q. Perhaps I convinced him that Tobin's Q is just not relevant to this analysis since the value of a firm is affected by so many factors other than items accountants book into the ledgers. I discuss this problem with Tobin's Q at
http://www.cs.trinity.edu/~rjensen/temp/HolidayInnCaseSeeds.htm

In any case I hope Tom will continue our debate on replacement costs. My challenge to him remains to take my two Holiday Inn case seeds and show how replacement cost measures "are the only possible way for accounting to reflect wealth invested by shareholders in an enterprise; and consequently, changes in invested wealth" in these two hotels.
http://www.cs.trinity.edu/~rjensen/temp/HolidayInnCaseSeeds.htm

February 7, 2013 Update

From PwC on February 5, 2013
Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income
On February 5, 2013, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update No. 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income. This guidance is the culmination of the board's redeliberation on reporting reclassification adjustments from accumulated other comprehensive income. The new requirements will take effect for public companies in interim and annual reporting periods beginning after December 15, 2012 (the first quarter of 2013 for public, calendar-year companies).
http://www.pwc.com/en_US/us/cfodirect/assets/pdf/in-brief/in-brief-2013-05-fasb-other-comprehensive-income.pdf

Question
If the media insists on reporting one earnings number, which of the alternative earnings numbers should be reported?
In particular, should net earnings be reported before or after remeasuring financial instruments for unrealized changes in fair value?

Hint
The following paper has a great summary of the history of OCI and problems facing the FASB and IASB as we look to the future of financial reporting of business firms.

"Academic Research and Standard-Setting: The Case of Other Comprehensive Income," by Lynn L. Rees and Philip B. Shane, Accounting Horizons, December 2012, Vol. 26, No. 4, pp. 789-815. ---
http://aaajournals.org/doi/full/10.2308/acch-50237 

This paper links academic accounting research on comprehensive income reporting with the accounting standard-setting efforts of the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). We begin by discussing the development of reporting other comprehensive income, and we identify a significant weakness in the FASB's Conceptual Framework, in the lack of a cohesive definition of any subcategory of comprehensive income, including earnings. We identify several attributes that could help allocate comprehensive income between net income, other comprehensive income, and other subcategories. We then review academic research related to remaining standard-setting issues, and identify gaps in academic research where hypotheses could be developed and tested. Our objectives are to (1) stimulate standard-setters to better conceptualize what is meant by other comprehensive income and to distinguish it from earnings, and (2) stimulate researchers to develop and test hypotheses that might help in that process.

. . .

Potential Alternative Definitions of Earnings

Table 1 summarizes and categorizes various standard-setting issues related to reporting comprehensive income, and provides the organizing structure for our literature review later in the paper. The most important of these issues is the definition of earnings, or what makes up earnings and how it is distinguished from OCI. This is a “cross-cutting” issue because it arises when the Boards deliberate on various topics. The Boards cooperatively initiated the financial statement presentation project intending, in part, to solve the comprehensive income composition problem, but the project was subsequently delayed.

Table 2 presents a list of the specific comprehensive income components under current U.S. GAAP that require recognition as OCI. The second column presents the statement that provided financial reporting guidance for the OCI component, along with its effective date. The effective dates provide an indication as to how the OCI components have expanded over time. Since the issuance of Statement No. 130, which established formal reporting of OCI, new OCI-expanding requirements were promulgated in Statement No. 133. Financial instruments, insurance, and leases are three examples of topics currently on the FASB's agenda where OCI has been discussed as an option to report various gains and losses. In all these discussions, a framework is lacking that can guide standard-setter decisions. The increased use of accumulated OCI to capture various changes in net assets and the likely expansion of OCI items reinforce the notion that standard-setters must eventually come to grips with the distinction between OCI and earnings, or even whether the practice of reporting OCI with recycling should be retained.7

Presumably, elements with similar informational attributes should be classified together in financial statements. It is unclear what attributes the items listed in Table 2 possess that result in their being characterized differently from other components of income. Notably, the basis for conclusions of the FASB standards gives little to no economic reasoning for the decision to place these items in OCI. While not exhaustive, Table 2 presents four attributes that standard-setters could potentially use to distinguish between earnings and OCI: (1) the degree of persistence of the item, (2) whether the item results from a firm's core operations, (3) whether the item represents a change in net assets that is reasonably within management's control, and (4) whether the item results from remeasurement of an asset/liability. We discuss in turn the merits and potential problems of using these attributes to form a reporting framework for comprehensive income.

Degree of Persistence.

The degree of persistence of various comprehensive income components has significant implications for firm value (e.g., Friedman 1957; Kormendi and Lipe 1987; Collins and Kothari 1989). Ohlson's (1995, 1999) valuation model places a heavy emphasis on earnings persistence, which suggests that a reporting format that facilitates identifying the level of persistence across income components could be useful to investors. Examples abound as to how the concept of income persistence has been used in standard-setting, including separate presentation in the income statement for one-time items, extraordinary items, and discontinued operations. Standard-setters have justified several footnote disclosures (segmental disclosures) and disaggregation requirements (e.g., components of pension expense) on the basis of providing information to financial statement users about the persistence of various income statement components.

Thus, the persistence of revenue and expense items potentially could serve as a distinguishing characteristic of earnings and OCI. Table 2 shows that we regard all the items currently recognized in OCI as having relatively low persistence. However, several other low-persistence items are not recognized in OCI; for example, gains/losses on sale of assets, impairments of assets, restructuring charges, and gains/losses from litigation. To be consistent with this definition of OCI, the current paradigm must change significantly, and the resulting total for OCI would look substantially different from what it is now.

Using persistence of an item to distinguish earnings from OCI would create significant problems for standard-setters. Persistence can range from completely transitory (zero persistence) to permanent (100 percent persistence). At what point along this range is an item persistent enough to be recorded in earnings? While restructuring charges are typically considered as having low persistence, if they occur every two to three years, is this frequent enough to be classified with other earnings components or infrequent enough to be classified with OCI? Furthermore, the relative persistence of an item likely varies across industries, and even across firms.

In spite of these inherent difficulties, standard-setters could establish criteria related to persistence that they might use to ultimately determine the classification of particular items. In addition, standard-setters would not be restricted to classifying income components in one of two categories. As an example, highly persistent components could be classified as part of “recurring earnings,” medium-persistence items could go to “other earnings,” and low-persistence items to OCI (or some other nomenclature). Standard-setters could create additional partitions as needed.

Core Operations.

Classifying income components as earnings or OCI based on whether they are part of a firm's core operations is intuitively appealing. This criterion is related to income persistence, as we would expect core earnings to be more persistent than noncore income items. Furthermore, classifying income based on whether it is part of core operations has a long history in accounting.

In current practice, companies and investors place primary importance on some variant of earnings. However, it is not clear which variant of earnings is superior. Many companies report pro forma net income, which presumably provides investors with a more representative measure of the company's core income, but definitions of pro forma earnings vary across firms. Similarly, analysts tend to forecast a company's core earnings (Gu and Chen 2004). Evidence in prior research indicates that pro forma earnings and actual earnings forecasted by analysts are more closely associated with share prices than income from continuing operations based on current U.S. GAAP (e.g., Bradshaw and Sloan 2002; Bhattacharya et al. 2003).

The problems inherent with this attribute are similar to those of the earnings-persistence criterion. No generally accepted definition of core operations exists. At what point along a continuum does an activity become part of the core operations of a business? As Table 2 indicates, classifying gains/losses from holding available-for-sale securities as part of core earnings depends on whether the firm operates in the financial sector. Different operating environments across firms and industries could make it difficult for standard-setters to determine whether an item belongs in core earnings or OCI.8 In addition, differences in application across firms may give rise to concerns about comparability and potential for abuse on the part of managers in exercising their discretion (e.g., Barth et al. 2011).

The FASB's (2010) Staff Draft on Financial Statement Presentation tries to address the definitional issue by using interrelationships and synergies between assets and liabilities as a criterion to distinguish operating (or core) activities from investing (or noncore) activities. Specifically, the Staff Draft states:

An entity shall classify in the operating category:

Assets that are used as part of the entity's day-to-day business and all changes in those assets Liabilities that arise from the entity's day-to-day business and all changes in those liabilities.

Operating activities generate revenue through a process that requires the interrelated use of the entity's resources. An asset or a liability that an entity uses to generate a return and any change in that asset or liability shall be classified in the investing category. No significant synergies are created for the entity by combining an asset or a liability classified in the investing category with other resources of the entity. An asset or a liability classified in the investing category may yield a return for the entity in the form of, for example, interest, dividends, royalties, equity income, gains, or losses. (FASB 2010, paras. 72, 73, 81)

The above distinction between operating activities and investing activities could similarly be used to distinguish between core activities and noncore activities. Alternatively, standard-setters might develop other definitions. Similar to the degree of persistence attribute, standard-setters would not be restricted to a simple core versus noncore dichotomy when using this definition.

Another possible solution is to allow management to determine which items belong in core earnings. Companies exercise this discretion today when they choose to disclose pro forma earnings. Furthermore, the FASB established the precedent of the “management approach” when it allowed management to determine how to report segment disclosures. In several other areas of U.S. GAAP, management is responsible for establishing boundaries that define its operating environment. FASB Accounting Standards Codification Topic 320 (formerly Statement 115) permits different measurements for identical investments based on management's intent to sell or hold the instrument. Other examples where U.S. GAAP allows for management discretion include determining the rate to discount pension liabilities, defining reporting units, and determining whether an impairment is other than temporary. However, the management approach accentuates the concern about comparability and potential for abuse.

Management Control.

Given a premise that evaluating management's stewardship is a primary role of financial statements, a possible rationale for excluding certain items from earnings is that they do not provide a good measure to evaluate management.9 Management can largely control the firm's operating costs and can influence the level of revenues generated. However, some decisions that affect comprehensive income can be established by company policy or the company mission statement and, thus, be outside the control of management. For example, a company policy might be to invest excess cash in marketable securities with the objective of maximizing returns. Once the board of directors establishes this policy, management has little influence over how market-wide fluctuations in security prices affect earnings, and hedging the gains/losses would be inconsistent with the objective of maximizing returns. Similarly, a company's mission statement might include expansion overseas, or prior management might have already decided to establish a foreign subsidiary. The resulting gains/losses from foreign currency fluctuations would seemingly be out of management's control, and hedging these gains/losses would not make economic sense if the subsidiary's functional currency is its local currency and the parent has no intention of repatriating the subsidiary's cash flows.

Of course, determining what is and is not ostensibly under management's control becomes highly subjective and would probably differ across industries, and perhaps even across firms within industries. For example, gains/losses from investment holdings might not be relevant in evaluating management of some companies, but might be very relevant for managers of holding companies. In addition, the time horizon affects what is under management's control. That is, as the time horizon lengthens, more things are under management's control.

In Table 2, we classify items as not under management's control if they are based on fluctuations in stock prices or exchange rates, which academic research shows to be largely random within efficient markets. Using this classification model, most, but not all, of the OCI items listed in Table 2 are classified as not under the management's control. Some of the pension items currently recognized in OCI are within the control of management, because management controls the decision to revise a pension plan. While management has control over when to harvest gains/losses on available-for-sale (AFS) securities by deciding when to sell the securities, it cannot control market prices. Thus, under this criterion, unrealized gains/losses on AFS securities are appropriately recognized in OCI. However, gains/losses on trading securities and the effects of tax rate changes are beyond management's control, and yet, these items are currently included as part of earnings. Thus, “management control” does not distinguish what is and is not included in earnings under current U.S. GAAP.

Remeasurements.

Barker (2004) explains how the measurement and presentation of comprehensive income might rely on remeasurements. The FASB's (2010) Staff Draft on Financial Statement Presentation defines remeasurements as follows:

A remeasurement is an amount recognized in comprehensive income that increases or decreases the net carrying amount of an asset or a liability and that is the result of:

A change in (or realization of) a current price or value A change in an estimate of a current price or value or A change in any estimate or method used to measure the carrying amount of an asset or a liability. (FASB 2010, para. 234)

Using this definition, examples of remeasurements are impairments of land, unrealized gains/losses due to fair value changes in securities, income tax expenses due to changes in statutory tax rates, and unexpected gains/losses from holding pension assets. All of these items represent a change in carrying value of an already existing asset or liability due to changes in prices or estimates (land, investments, deferred tax asset/liability, and pension asset/liability, respectively).

Table 3 reproduces a table from Barker (2004) that illustrates how a firm's income statement might look using a “matrix format” if standard-setters adopt the remeasurement approach to reporting comprehensive income. Note that the presentation in Table 3 does not employ earnings as a subtotal of comprehensive income; however, the approach could be modified to define earnings as the sum of all items before remeasurements, if considered useful. Tarca et al. (2008) conduct an experiment with analysts, accountants, and M.B.A. students to assess whether the matrix income statement format in Table 3 facilitates or hinders users' ability to extract information. They find evidence suggesting that the matrix format facilitates more accurate information extraction for users across all sophistication levels relative to a typical format based on IAS 1.

 

Table 3:  Illustration of Matrix Reporting Format

 

Employing remeasurements to distinguish between earnings and other comprehensive income largely incorporates the criterion of earnings persistence. Most remeasurements result from price changes, where the current change has little or no association with future changes and, therefore, these components of income are transitory. In contrast, earnings components before remeasurements generally represent items that are likely more persistent.

Perhaps the most significant advantage of the remeasurement criterion is that it is less subjective than the other criteria previously discussed. Most of the other criteria in Table 2 are continuous in nature. Drawing a bright line to differentiate what belongs in earnings from what belongs in OCI is challenging and will likely be susceptible to income manipulation. In contrast, determining whether a component of income arises from a remeasurement is more straightforward.

Yet another advantage of this approach is it allows for a full fair value balance sheet that clearly discloses the effects of fair value measurement on periodic comprehensive income, while also showing earnings effects under a modified historical cost system (i.e., before remeasurements). This approach could potentially provide better information about probable future cash flows.

Other.

The attributes standard-setters could use to classify income components into earnings or OCI are not limited to the list in Table 2. Ketz (1999) suggests using the level of measurement uncertainty. As an example, gains/losses from Level 1 fair value measurements might be viewed as sufficiently certain to include in earnings, while Level 3 fair value measurements might generate gains/losses that belong in OCI. Song et al. (2010) provide some support for this partition in that they document the value relevance of Level 1 and Level 2 fair values exceeds the value relevance of Level 3 fair values.

Another potential attribute might be the horizon over which unrealized gains/losses are ultimately realized. That is, unrealized gains/losses from foreign currency fluctuations, term life insurance contracts, or holding pension assets that will not be realized for many years in the future might be disclosed as part of OCI, whereas unrealized gains/losses from trading and available-for-sale securities could be part of earnings.

As previously discussed, the attributes of measurement uncertainty and timeliness create similar problems in determining where to draw the line. Which items are sufficiently reliable (or timely) to include in earnings, and will differences in implementation across firms and industries impair comparability?

The overriding purpose of the discussion in this subsection is to point out that several alternative attributes could potentially guide standard-setters in establishing criteria to differentiate earnings from OCI. Ultimately, the choice regarding whether/how to distinguish net income from OCI is a matter of policy. However, academic research can inform policy decisions, as described in the fourth and fifth sections.

Summary

Reporting OCI is a relatively recent phenomenon that presumes financial statement users are provided with better information when specific comprehensive income components are excluded from earnings-per-share (EPS), and recycled back into net income only after the occurrence of a specified transaction or event. The number of income components included in OCI has increased over time, and this expansion is likely to continue as standard-setters address new agenda items (e.g., financial instruments and insurance contracts). The lack of a clear definitional distinction between earnings and OCI in the FASB/IASB Conceptual Frameworks has led to: (1) ad hoc decisions on the income components classified in OCI, and (2) no conceptual basis for deciding whether OCI should be excluded from earnings-per-share (EPS) in the current period or recycled through EPS in subsequent periods. In this section, we discussed alternative criteria that standard-setters could use to distinguish earnings from OCI, along with the advantages and challenges of each criterion. Further, due to the inherent difficulties in drawing bright lines between earnings that are persistent versus transitory, core versus noncore, under management control or not, and amenable to remeasurement or not, standard-setters might consider eliminating OCI; that is, they might decide to adopt an all-inclusive income statement approach, where comprehensive income is reporte

. . .

Continued in article

Jensen Comment
I like this paper. Table 3 could be improved by adding bottom line net earnings before and after remeasurement.

The paper does not provide all the answers, but it is well written in terms of history up to this point in time and alternative directions for consideration.

No Bottom Line

Question
Is a major overhaul of accounting standards on the way?
Hint
There may no longer be the tried and untrusted earnings per share number to report!
Comment
It would be interesting to see a documentation of the academic research, if any, that the FASB relied upon to commence this blockbuster initiative. I recommend that some astute researcher commence to probe into the thinking behind this proposal.

"Profit as We Know It Could Be Lost With New Accounting Statements," by David Reilly, The Wall Street Journal, May 12, 2007; Page A1 --- http://online.wsj.com/article/SB117893520139500814.html?mod=DAT

Pretty soon the bottom line may not be, well, the bottom line.

In coming months, accounting-rule makers are planning to unveil a draft plan to rework financial statements, the bedrock data that millions of investors use every day when deciding whether to buy or sell stocks, bonds and other financial instruments. One possible result: the elimination of what today is known as net income or net profit, the bottom-line figure showing what is left after expenses have been met and taxes paid.

It is the item many investors look to as a key gauge of corporate performance and one measure used to determine executive compensation. In its place, investors might find a number of profit figures that correspond to different corporate activities such as business operations, financing and investing.

Another possible radical change in the works: assets and liabilities may no longer be separate categories on the balance sheet, or fall to the left and right side in the classic format taught in introductory accounting classes.

ACCOUNTING OVERHAUL

Get a glimpse of what new financial statements could look like, according to an early draft recently provided by the Financial Accounting Standards Board to one of its advisory groups. The overhaul could mark one of the most drastic changes to accounting and financial reporting since the start of the Industrial Revolution in the 19th century, when companies began publishing financial information as they sought outside capital. The move is being undertaken by accounting-rule makers in the U.S. and internationally, and ultimately could affect companies and investors around the world.

The project is aimed at providing investors with more telling information and has come about as rule makers work to one day come up with a common, global set of accounting standards. If adopted, the changes will likely force every accounting textbook to be rewritten and anyone who uses accounting -- from clerks to chief executives -- to relearn how to compile and analyze information that shows what is happening in a business.

This is likely to come as a shock, even if many investors and executives acknowledge that net income has flaws. "If there was no bottom line, I'd want to have a sense of what other indicators I ought to be looking at to get a sense of the comprehensive health of the company," says Katrina Presti, a part-time independent health-care contractor and stay-at-home mom who is part of a 12-woman investment club in Pueblo, Colo. "Net income might be a false indicator, but what would I look at if it goes away?"

The effort to redo financial statements reflects changes in who uses them and for what purposes. Financial statements were originally crafted with bankers and lenders in mind. Their biggest question: Is the business solvent and what's left if it fails? Stock investors care more about a business's current and future profits, so the net-income line takes on added significance for them.

Indeed, that single profit number, particularly when it is divided by the number of shares outstanding, provides the most popular measure of a company's valuation: the price-to-earnings ratio. A company that trades at $10 a share, and which has net profit of $1 a share, has a P/E of 10.

But giving that much power to one number has long been a recipe for fraud and stock-market excesses. Many major accounting scandals earlier this decade centered on manipulation of net income. The stock-market bubble of the 1990s was largely based on investors' assumption that net profit for stocks would grow rapidly for years to come. And the game of beating a quarterly earnings number became a distraction or worse for companies' managers and investors. Obviously it isn't known whether the new format would cut down on attempts to game the numbers, but companies would have to give a more detailed breakdown of what is going on.

The goal of the accounting-rule makers is to better reflect how businesses are actually run and divert attention from the one number. "I know the world likes single bottom-line numbers and all of that, but complicated businesses are hard to translate into just one number," says Robert Herz, chairman of the Financial Accounting Standards Board, the U.S. rule-making body that is one of several groups working on the changes.

At the same time, public companies today are more global than local, and as likely to be involved in services or lines of business that involve intellectual property such as software rather than the plants and equipment that defined the manufacturing age. "The income statement today looks a lot like it did when I started out in this profession," says William Parrett, the retiring CEO of accounting firm Deloitte Touche Tohmatsu, who started as a junior accountant in 1967. "But the kind of information that goes into it is completely different."

Along the way, figures such as net income have become muddied. That is in part because more and more of the items used to calculate net profit are based on management estimates, such as the value of items that don't trade in active markets and the direction of interest rates. Also, over the years rule makers agreed to corporate demands to account for some things, such as day-to-day changes in the value of pension plans or financial instruments used to protect against changes in interest rates, in ways that keep them from causing swings in net income.

Rule makers hope reformatting financial statements will address some of these issues, while giving investors more information about what is happening in different parts of a business to better assess its value. The project is being managed jointly by the FASB in the U.S. and the London-based International Accounting Standards Board, and involves accounting bodies in Japan, other parts of Asia and individual European nations.

The entire process of adopting the revised approach could take a few years to play out, so much could yet change. Plus, once rule makers adopt the changes, they would have to be ratified by regulatory authorities, such as the Securities and Exchange Commission in the U.S. and the European Commission in Europe, before public companies would be required to follow them.

As a first step, rule makers expect later this year to publish a document outlining their preliminary views on what new form financial statements might take. But already they have given hints of what's in store. In March, the FASB provided draft, new financial statements at the end of a 32-page handout for members of an advisory group. (See an example.)

Although likely to change, this preview showed an income statement that has separate segments for the company's operating business, its financing activities, investing activities and tax payments. Each area has an income subtotal for that particular segment.

There is also a "total comprehensive income" category that is wider ranging than net profit as it is known today, and so wouldn't be directly comparable. That is because this total would likely include gains and losses now kept in other parts of the financial statements. These include some currency fluctuations and changes in the value of financial instruments used to hedge against other items.

Comprehensive income could also eventually include short-term changes in the value of corporate pension plans, which currently are smoothed out over a number of years. As a result, comprehensive income could be a lot more difficult to predict and could be volatile from quarter to quarter or year to year.

As for the balance sheet, the new version would group assets and liabilities together according to similar categories of operating, investing and financing activities, although it does provide a section for shareholders equity. Currently, a balance sheet is broken down between assets and liabilities, rather than by operating categories.

Such drastic change isn't likely to happen without a fight. Efforts to bring now-excluded figures into the income statement could prompt battles with companies that fear their profit will be subject to big swings. Companies may also balk at the expense involved.

"The cost of this change could be monumental," says Gary John Previts, an accounting professor at Case Western Reserve University in Cleveland. "All the textbooks are going to have to change, every contract and every bank arrangement will have to change." Investors in Europe and Asia, meanwhile, have opposed the idea of dropping net profit as it appears today, David Tweedie, the IASB's chairman, said in an interview earlier this year.

Analysts in the London office of UBS AG recently published a report arguing this very point -- that even if net income is a "simplistic measure," that doesn't mean it isn't a valid "starting point in valuation" and that "its widespread use is justification enough for its retention."

Such opposition doesn't surprise many accounting experts. Net income is "the basis for bonuses and judgments about what a company's stock is worth," says Stephen A. Zeff, an accounting professor at Rice University. "I just don't know what the markets would do if companies stopped reporting a bottom line somewhere." In the U.S., professional investors and analysts have taken a more nuanced view, perhaps because the manipulation of numbers was more pronounced in U.S. markets.

That said, net profit has been around for some time. The income statement in use today, along with the balance sheet, generally dates to the 1940s when the SEC laid out regulations on financial disclosure. But many companies have included net profit in one form or another since the 1800s.

In its fourth annual report, General Electric Co. provided investors with a consolidated balance sheet and consolidated profit-and-loss account for the year ended Jan. 31, 1896. The company, whose board at the time included Thomas Edison, generated "profit of the year" -- what today would be called net income or net profit -- of $1,388,967.46.

For the moment, net profit will probably exist in some form, although its days are likely numbered. "We've decided in the interim to keep a net-income subtotal, but that's all up for discussion," the FASB's Mr. Herz says.

Bob Jensen's summary of accounting theory is at http://www.trinity.edu/rjensen/Theory01.htm

Question
What do CFO's think of Robert Herz's (Chairman of the FASB) radical proposed  format for financial statements that have more disaggregated financial information and no aggregated bottom line?

As we moved to fair value accounting for derivative financial instruments (FAS 133) and financial instruments (FAS 157 and 159) coupled with the expected new thrust for fair value reporting on the international scene, we have filled the income statement and the retained earnings statement with more and more instability due to fluctuating unrealized gains and losses.

I have reservations about fair value reporting --- http://www.trinity.edu/rjensen/Theory01.htm#FairValue

But if we must live with more and more fair value reporting, the bottom line has to go. But CFOs are reluctant to give up the bottom line even if it may distort investing decisions and compensation contracts tied to bottom-line reporting.

Before reading the article below you may want to first read about radical new changes on the way --- http://www.trinity.edu/rjensen/Theory01.htm#ChangesOnTheWay