Representational Faithfulness of the Balance Sheet in the New Business Paradigm (2000)

ABSTRACT Some accountants are becoming increasingly concerned over what many users of financial information perceive as the growing gap between the actual assets of business enterprises and the assets reported on their balance sheets. This gap may be more significant for companies with knowledge and service based business models-which are particularly important in the new business paradigm centered around communications and information. Thus, for these companies the balance sheet may not be representationally faithful. In our study, we test the representational faithfulness of balance sheets using an assumption that the relationship of the market value and book value of a company's stock (PRBV) is an indicator of the representational faithfulness of the balance sheet in reporting the economic resources of a business enterprise. A sample was taken from the Value Line data base of 200 companies with the highest PRBV multiples and 200 companies with the lowest PRBV multiples to determine which type of industries tended to fall in the high and low categories. We also collected data on the 400 companies to examine other variables that could contribute to our understanding of the differences that exist between the high and low groups. We observed a predominance of knowledge and service based companies in the high group and a predominance of more traditional companies in the low group. Further, we found that the high PRBV companies have higher market risk, a higher growth rate and lower levels of capital intensity. Accordingly, we conclude that the balance sheets of knowledge and service based companies of the new business paradigm may systematically under-report assets. BACKGROUND The role of financial reporting in the economy is to provide information that is useful in making business and economic decisions. The FASB has concluded, as expressed in their Statement of Financial Accounting Concepts No. 1 : Objectives of Financial Reporting by Business Enterprises, issued in November 1978, that financial reporting should provide information about an enterprise's economic resources, obligations, and owners' equity (FASB, 1978). This is merely the confirmation of a long standing and widely recognized convention in financial reporting that the balance sheet is basic to financial accounting. Indeed, the measurement of an entity's assets, liabilities and owners equity is the foundation of the financial accounting model. However, many accountants and users of financial accounting information are becoming increasingly concerned that the emerging focus of business enterprises toward a service and knowledge based product is resulting in balance sheets which omit certain assets of such business enterprises. If true, balance sheets for companies in the service and knowledge based sectors of the economy may be losing their representational faithfulness and their relevance. One reason for the omission of assets of knowledge and or service based companies is that some of the assets of these companies are of a soft intangible nature as opposed to the comparatively hard and tangible nature of assets of more traditional business enterprises like heavy manufacturing and traditional wholesaling/retailing. The primary qualities that make accounting information useful are relevance and reliability (FASB, 1980). Because of the inherent reliability problems associated with soft intangible assets and accounting's traditional adherence to conservatism, many of these assets are not recognized and the resulting balance sheets may lack representational faithfulness. The FASB defines representational faithfulness as the ...correspondence or agreement between a measure or description and the phenomenon it purports to represent. In accounting, the phenomena to be represented are economic resources.... (FASB , 1980). Thus, by leaving out important assets of knowledge and service based companies, their balance sheets may not faithfully represent the companies' financial position. …