Financial Reporting

When Daniel Day-Lewis strikes oil in “There Will Be Blood,” that’s the moment his character becomes wealthy—not years later when the oil is extracted and sold. Yet accounting treats this wealth-creating discovery as if it never happened, recognizing zero value until decades of extraction begin.

This disconnect between economic reality and financial reporting isn’t just a Hollywood illustration—it’s emblematic of a fundamental flaw plaguing our entire theory of accounting. In this episode of the Earmark Podcast, I spoke with Thomas Selling, author of The Accounting Onion blog and former SEC regulatory expert, about how financial reporting systematically fails to capture when and how businesses actually create value.

Thomas argues that the fundamental problem with modern accounting isn’t complexity or compliance—it’s a structural flaw rooted in historical cost accounting. This creates massive timing disconnects between when businesses create economic value and when financial statements recognize it, forcing successful companies to appear unprofitable during critical growth phases while handing management dangerous tools to manipulate earnings at shareholders’ expense.

Our wide-ranging discussion explored how these timing problems plague industries from oil and gas to pharmaceuticals to software subscriptions, why historical cost accounting enables manipulation through what Thomas calls accounting’s “truth in labeling problem,” and what radical alternatives could create more honest financial reporting that actually serves investors.

The Historical Cost Problem: When Transactions Trump Assets

Historical cost accounting sits at the foundation of our financial reporting system, but Thomas says it’s built on a fundamental misconception. “Historical cost is not actually an attribute of an asset,” he explained, “but rather an attribute of the transaction that acquired the asset.” This distinction might sound technical, but it creates the framework for timing disconnects and manipulation opportunities plaguing modern accounting daily.

Think about it this way: if you bought a house ten years ago, you don’t think about the purchase price as describing the house itself. You consider what it would cost to replace the house if you moved, or how much you could sell it for today. Yet accounting theory stubbornly clings to that decade-old transaction price as if it tells us something meaningful about the current asset.

As Walter Schuetze, former SEC Chief Accountant whom Thomas worked under, famously put it: “We report a truck as if the cost of the truck is the asset as opposed to the truck itself.” This creates what Thomas calls a “truth in labeling problem”—we claim to provide relevant information about assets while actually providing information about historical transactions that may have occurred years or decades ago.

The manipulation opportunities this creates are staggering. Historical cost enables what Thomas calls “cherry picking”—companies can sell assets that will show the most gain in any given period simply because the carrying amount bears no relationship to current reality. This isn’t theoretical—it’s exactly what brought down Enron.

The energy giant had power plants that were performing well but had been fully depreciated on the books. When Enron needed to boost its numbers, it created fictitious entities with essentially fictitious investors and “sold” those power plants to them. Enron recorded massive gains while hiding enormous debt levels in special purpose entities. “They were able to convince the auditors that these were genuine sales,” Thomas explained. “But, in fact, what happened is that these assets came back to Enron along with the debt, and they couldn’t handle the level of debt they had.”

Even the complex impairment rules that fill thousands of pages of GAAP exist solely because historical cost creates such distortive measurements. Under current rules, an asset worth $1 million in historical cost isn’t considered impaired if expected future cash flows are $1,000,001—even if that cash flow won’t arrive for five years and ignores the time value of money entirely. But drop those expected cash flows by just $2 to $999,999, and suddenly you have an impairment loss of hundreds of thousands of dollars when you discount that future cash flow to present value.

These systematic flaws give management what Thomas describes as tools to manipulate earnings while creating financial statements that often bear little resemblance to economic reality.

The Great Timing Disconnect: When Value Creation and Recognition Don’t Match

The most dramatic evidence of accounting’s structural flaws emerges when examining industries where value creation and revenue recognition are separated by years or decades.

Consider the extractive industries, which represent a massive portion of global economic activity through oil, gas, metals, and minerals. Thomas estimates that roughly 80% of an oil and gas company’s value creation occurs at a single moment: when they discover reserves. “The value-creating event is the discovery of reserves,” he explained, pointing to how stock prices immediately jump when companies file 8-K forms announcing new discoveries.

Yet GAAP treats this wealth-creating discovery as a complete non-event. “When does GAAP recognize the first penny of those earnings?” Thomas asked. The answer floored me: somewhere between 5 and 50 years later, when the last drop finally comes out of the ground. “It’s going to take five years to develop it. You turn the spigot on, the last drop is going to come out 50 years from now.”

This timing problem isn’t limited to extractive industries. Pharmaceuticals face identical challenges where the value-creating event is drug discovery, but revenue recognition occurs years later after development, testing, and approval. “The value-creating event is the discovery of a new drug,” Thomas noted. “Think of how many years go by before you get the first dollar of revenue.”

But perhaps nowhere is this disconnect more visible than in subscription businesses, where my firsthand experience reveals the absurdity of current accounting rules. In software-as-a-service companies, the moment of value creation is customer acquisition. These businesses can reliably estimate customer lifetime value through proven metrics like churn rates, average contract prices, and customer lifespan data.

“Every customer that you bring on has a lifetime value of X dollars,” I explained to Thomas. “When I sign up that customer, economically what is happening is I am basically adding those future cash flows to my business.” Yet these economically real and measurable future cash flows never appear on the balance sheet. Meanwhile, 100% of the marketing and sales expenses to acquire that customer hit the income statement immediately.

This creates what I see as a violation of basic accounting principles, though Thomas clarified that under current FASB thinking, “the matching principle no longer exists.” What remains is conservatism—recognizing expenses immediately while deferring revenue recognition. This makes successful subscription businesses appear horribly unprofitable during growth phases, exactly what happened with Amazon while building its enormously valuable Prime subscriber base.

These timing disconnects don’t just confuse investors—they actively distort capital allocation decisions across the entire economy, making some of the most valuable business models appear fundamentally unprofitable during their most crucial growth phases.

Beyond Earnings: A Balance Sheet Revolution

The solution to accounting’s structural problems isn’t trying to fix earnings measurement—it’s abandoning the obsession with earnings entirely. Thomas argues there’s no universal “right number for earnings,” and accounting should instead focus on what the FASB has correctly identified as its real purpose.

“The FASB concluded for good reason, that they should be in the business of measuring assets and liabilities and that reported… earnings… is a function of changes in assets and liabilities, not the other way around,” Thomas explained. Instead of chasing some mythical perfect earnings number, financial reporting should provide accurate, detailed information about what companies actually own and owe.

Thomas proposed four specific alternatives to historical cost measurement. Fair value measures what you could sell an asset for today—we’ve already seen this implemented for crypto assets. Replacement cost measures what it would cost to acquire equivalent assets today. Net present value calculates the present value of future cash flows for assets where those flows can be estimated.

But Thomas’s preferred approach is “deprival value”—a hybrid that measures how much utility a company would lose if deprived of an asset. “If somebody took your house from you, the deprival value would be the replacement cost, because you would have to replace it,” he explained. For outdated inventory you weren’t planning to replace, the deprival value would be whatever you could sell it for.

The estimation challenge is real—moving away from historical cost requires more judgments about current values. But as Thomas pointed out, our current system already relies heavily on estimates, just bad ones embedded in a perverse structure. “It’s like asking students to grade their own papers,” he said, describing how management makes the estimates that determine their own performance, while auditors can only reject obviously unreasonable numbers.

This explains why companies fight basic transparency measures. Thomas pointed to decades-long battles over requiring direct method cash flow statements showing actual cash receipts from customers and payments to vendors. “Management fights tooth and nail a requirement to have a statement of cash flows using the direct method,” he noted, because transparency doesn’t serve their interests.

Thomas’s vision is radical in its simplicity: replace 8,000 pages of complex GAAP with perhaps 200 pages of clear principles focused on measuring assets and liabilities in relevant ways. This would “supercharge” investors with detailed information about how asset values change over time, allowing users to construct whatever performance measures they find most relevant rather than accepting GAAP’s one-size-fits-all approach.

The Path Forward: From Accounting Theater to Economic Reality

My conversation with Thomas Selling revealed a profession at a crossroads, driven by what he describes as his “rage at how managers use accounting to steal from shareholders.” Current accounting systems don’t just have technical problems—they have fundamental structural flaws that actively distort economic reality and enable systematic manipulation.

When successful subscription businesses appear unprofitable during growth phases, when oil discoveries worth billions show as non-events on financial statements, and when management can game impairment rules with surgical precision, we’re witnessing what amounts to accounting theater rather than meaningful financial reporting.

The implications extend far beyond financial statements. These measurement failures affect capital allocation across the entire economy, from inefficient mergers driven by goodwill accounting quirks to investors systematically misunderstanding some of the most important business models of our time.

The rise of subscription models, platform businesses, and intangible asset-heavy companies has exposed historical cost accounting as increasingly obsolete for capturing how modern businesses create value.

The solution isn’t tweaking existing rules or adding more complexity to an already bloated system. It requires the kind of fundamental reformation Thomas advocates—what he’s calling “an accounting reformation” in his upcoming book. As he puts it, “Once managers can no longer manipulate income, they’ll have no economic reason to base their performance on earnings.”

This accounting reformation won’t be easy, given the entrenched interests that benefit from current opacity. But it represents a future where financial statements finally serve their intended purpose of informing capital allocation rather than obscuring it.

To hear Thomas’s detailed vision for this accounting reformation and his passionate case for why these changes are urgently needed, listen to the full episode of the Earmark Podcast.