The greatest error of the accounting reform recently introduced worldwide is that it scraps centuries of accounting experience and business management. It replaces the prudence principle, as the highest ranking among all traditional accounting principles, with the “fair-value” principle, which is simply the introduction of the volatile market value for an entire set of assets, particularly financial assets. FULL ARTICLE by Jesus Huerta de Soto.
Source link: http://blog.mises.org/9371/financial-crisis-the-failure-of-accounting-reform/
Financial Crisis: The Failure of Accounting Reform
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As a CPA and an ardent fiscal conservative watching the process take place over the last few years has left me to conclude that we now live fully in an era of sheer ignorance.
Is the “historical cost method” perfect? No. But it is conservative. It represents what has happened, objectively determined. If someone wants (like a bank) a full appraisal at market, certainly one can be provided. I’d think most banks, in the past, would have done a thorough review of their prospective debtor and made proper valuations at that time. Basically, speculators are given the most conservative picture and they can speculate up to their heart’s content that which may be undervalued.
But these “fair value” standards open up financials to rampant subjectivity and is a license to be as fiscally anti-conservative as a presenter wants to be. And just having felt the huge impact of a bursting bubble, the accounting profession thinks this is the absolute BEST time to move toward some “pull it out of the “air” methodology? The profession will then stop being the LAST bastion for conservative assessments and properly actuating equity and instead be full force behind nonsensical speculations, and reinforce miscalculations. It will go from being traffic cop to the main red light runner. People have an expectation that CPA “vetted” financial numbers have integrity. Now we will only be giving sanction to our nonsensical Federal misallocations that lead to massive distorting bubbles as it plays out in the street.
Even more chilling to me was attending an AICPA continuing education class on this very topic. And the whole tone was one of indoctrination, not education. The very last stage of the class was a list of issues and concerns that must have been generated over the debates, and the process was someone in the class would agree with an anti-fair value and the instructor would pick them apart, basically stating the AICPA’s position. It wasn’t a give and take, it was a ramming down the throat. It wasn’t about peers debating, it was about the AICPA dictating. I don’t think it is too coincidental that the AICPA has, for the first time, a President from the “governmental” side of the profession. I am dreadfully afraid of where we are headed.
It will be interesting. There is going to be some interesting times ahead for auditors as they mesh with burgeoning independent “fair valuers”. The auditor is going to be the one with all the risk as they are issuing the report but the fair-valuer will stand by their assessment. There’s going to be a lot of fighting going on between the client, the auditor, and the fair-valuers. It is going to create a mess.
I wonder if this just isn’t some seedlings planted by the Trial Lawyers of America knowing that “actionable” situations are going to explode out of all of this when stocks (et al) go bad. Suffice it to say these new standards make for a bureaucratic explosion. One has to wonder if the AICPA is complicit knowing that many of the fair-valuers are going to come from the accounting profession itself making an instant demand for, and likely shortage of, talent (and consequent larger salaries). But that would be an ignorant thing to do as the profession is already spread thin with talented people. So we now have new pronouncements that unleash speculative numbers while the profession is suffering finding good people to start with. The result is less sound numbers being audited and valued by poorer stock. But I guess that’s about in line with the degradation of our financial structure of the US. I guess the AICPA felt that couldn’t beat’em so they joined’em, and we are now completely screwed.
When the IRS uses “fair value” to extract additional tax on held assets, what other defense do companies have?
Of course it’s subjective — this is the result of decades of “self-esteem-building” exercises, where achievement and accomplishment don’t mean as much as effort, when kids’ games are unscored, when everyone’s opinion is as valid and valuable as anyone else’s — where “everyone who shows up is a winner.”
Garbage in, garbage out. Anyone for a second helping of garbage?
Nothing wrong with getting back to basics. If someone thinks their asset has a higher value and wants to realize it on their books, all they have to do is sell it at that high value and record it accordingly on their balance sheet. Same applies to taking losses.
Great article.
Very informative article. Are the “fair market value” accounting rules an attempt to hide the impacts of inflation or a recognition of the impact of inflation?
Having been a credit analyst these last two decades, I have been whining about the trumping of the prudence concept by the fair value concept for most of th elast . Prof de Soto hits the nail on the head.
Accounting for fair value is the elaborate quantification of a mirage. The mathematical analogue of Business English gobbledegook.
The inescapable fact is that nobody can definitively say what any asset is really worth until a sale occurs and a price is determined. And a moment later, the buyer faces a similar uncertainty.
So at a fundamental level, the entire accounting profession worldwide, and with it the whole of Western capitalism, fell for the same fallacy that lies at the heart of the Ricardian Labour theory of value – And considering that theory’s eventual home as the centrepiece of Marxism, the irony is exquisite.
All the technical quibbling in this article quite overlooks the elephant in the living room: the government. Starting with the SEC in 1933, “the” government (US in that case) got involved in how productive enterprises go about advertising their financial position and results (yes, accounting most definitely IS a specialized form of advertising).
Government, and the political processes that drive it, is an end unto itself, and it is an end that is inherently hostile to (and parasitic on) productive activity. It DISserves the traditional audiences for accounting reports in the same ways that the prior freely evolved institutions served them.
As in the case of money and so many other things, accounting managed itself just fine before governmental intrusion. Now that we have government in this (and everything else), it (and everything else) is rapidly deteriorating into tragic dysfunctionality.
Expect more as government continues to grow.
Great article. It really points out the continuation of traveling down that road of ignorance by so many.
Brad made some great observations as a CPA . The fact that the president of the AICPA is from the govenmental area highlights the problems that will and have been created. What person with a governmental background truly understands how markets work and how businesses should perform their accounting so it reflects the business correctly? Typically governmental people are more interested in creating elaborate nonuseful bureaucracies. Of course the bottom line for them is to help all their friends at the expense of everyone else. Look at the recent Obama nominations that had to step aside due to “problems”.
Why do we mark-to-market only when market value falls? It seems that this loss, and subsequent decrease in balance sheet size, is as unlikely to materialize as is a surplus, which would increase the balance sheet size, at least insofar as we as accountants are able to tell. Please shed the light of logic and truth on this issue for me.
Sincerely,
Matthew Wade
Matthew,
Mark to market works on both sides of the value trade allowing companies to speculate on increased value or forced liquidation as values fall.
Builders are currently using the mark to market rule to write down the value of their land holdings against current earnings resulting in huge losses. With these huge losses, they can file NOL’s against profitable years to get refunds on previous year taxes.
The funny thing here is that they are not selling this land and realizing the losses, they are just paper losses. As a result, some of these builders are recording huge losses but their cash position is continuing to build while they continue to pay dividends.
Mark to market was suppose to make the world more transparent when in truth it opened the door for the companies to hide the truth.
Thank you for the response, Greg. My question stems from an apparent contradiction in Professor de Soto’s essay when he says: “Instead, the purpose of accounting is to permit the prudent management of each company and to prevent capital consumption, by applying strict standards of accounting conservatism (based on the prudence principle and the recording of either historical cost or market value, WHICHEVER IS LESS)” [emphasis added]. As you said, there are advantages to losses as well as gains, but if we are going to call for prudence, we mustn’t be two-faced about it. We must attack the mark-to-market rule itself, not the profits or losses that result from it, however unjust they may be in themselves. Perhaps I am confused about Professor de Soto’s point, but it seems clear: don’t mark-to-market when prices increase because large “paper” gains will result, but mark-to-market when prices fall, even though “paper” losses will result. I seem to need a little more light.
Sincerely,
Matthew Wade
There is nothing inherently wrong with MtM accounting. Can anybody suggest a meaningful question, that is, one in which the answer would enable management to better run a firm, for which the answer would be book value? I doubt it.
MtM was instituted in response to the Enron fiasco. If MtM had been around in the late 1970s, everyone would have known then that the S&Ls in the U.S. were broke. Using book values, though, allowed the charade to continue for another decade. Why was the use of book value more prudent here?
Where the use of MtM went wrong, as is painfully clear today, is requiring it in the financial statements. If firms were just required to include a detailed analysis of MtM results in the footnotes with, again, a detailed explanation of any divergences between it and the balances carried on the financials, investors would obtain the same, if not more, information. Today, with bid-ask spreads so wide, markets are less liquid, price discovery is hampered and because of Sarbanes-Oxley, firms are using the bid price. This resulted in the massive writedowns of assets which have to be balanced by writedowns in the equity account, thus reducing banks ability to lend.
As an example of how bizarre the outcome has been, writedowns of subprime mortgages have been in the neighborhood of $1Tr. This is equal to the total outstanding subprime mortgages. Does anyone seriously believe that every subprime mortgage is going to default and that all of the underlying assets are totally worthless? I didn’t think so.
I think that N. Joseph Potts hit the nail on the head. The problem isn’t mark to market, per se. It is the presence of an entity that believes that it can centrally plan the process of reporting financial results.
I am not an accountant. I work for an insurance company managing market risks present in insurance liabilities. In my work, I deal with the valuation of insurance liabilities. Some of them are marked to market while others follow a variety of convoluted rules.
As an insurance company, we do not want to retain the market risks in our liabilities. So we hedge it away. From experience, I can say that non-fair value accounting puts up obstacles to what, in my professional opinion, are prudent ways to manage the business. So in my experience, at least, I favor mark to market accounting in the context that we are hedging the market exposures.
As said, I am not an accountant. I am amenable to considering factors beyond my experience. Within the context of the economic/political discussion, I maintain though that the primary problem is one of centralized, coercive planning.
Good read, but the author doesn’t address the role that derivatives has played in the meltdown. The U.S. economy is financial-ized to the point where 5 institutions alone have created $175 trillion worth of derivatives — talk bout’ voo-doo economics — quite a trick in a $13 trillion dollar economy — ehhh.
In the US it’s the Fed (St. Louis) who keeps ‘official records’ as to what the velocity of money is. The measure of velocity is captured in a monthly publication called Monetary Trends. Arithmetically it is measured by the equation:
Velocity of Money = Nominal GDP / MZM [money supply of zero maturity]
Nominal GDP measures the value of current production in the monetary unit of the country. In an increasingly financial-ized economy where the growth in outstanding off-balance sheet notional derivatives (now measuring hundreds of trillions) has mushroomed since 1995 – nominal GDP does not, and never has adequately attempted to capture or measure this. The OBSCENE growth in these derivatives, with the Fed’s ‘stooge surrogate institution’ J.P. Morgan Chase leading the way, “IS†what predominantly has kept Wall Street fed for the past decade!!!! So how, in an increasingly financial-ized economy, can there be any valid reason for completely excluding them or their impact from nominal GDP?
Anyone with the slightest hint of reality, knows the worst is yet to come! The only question remaining “IS” can America afford to pick-up the tab of those who led the nation down the garden path listening to Alan’s ‘greenspeak’ without a clue of what he was saying.
Before MtM there was “lower of cost or market” principals in place, again in an effort to be conservative. So assets had to be written down but not up. And none of the indoctrination I received at my AICPA CE course talked about the advantages of writting down, it all had to do with writing up assets to be more representative. And finally, an assets stated value put on a machine makes no difference for OPERATING decisions. It is either useful or not in generating cash flow as it is used.
Without writing another longwinded treatise, it stands that for two centuries, from the Louisiana Purchase on, the Federal Government has been engaging in unconstitutional activities that basically lead to over-speculation. The brakes put in place by accountants historically (from the 1900′s on anyway) was to be conservative and so not feed into the over-speculation. We were the sensible people who tried to make equity a stable and quantifiable thing, hand in hand with the notion that equity accrues to individuals. With wild, government spurred bubbles coming every few years someone had to have a cool head. The government is generally run by lawyers and “game riggers” where fiscal conservativeness is non-existent.
Put another way, and put in layman’s terms, when we discuss values in terms of the market as far as stocks, for example, accountants understand that a stock’s value is really made up hard assets that have an intrinsic value of say, roughly, 20% of the value of the stock. The remainder ultimately is an investment in the management of those assets (people would be surprised how many Big Companies’ balance sheets are made up in huge proportion with goodwill and other intangibles). People can speculate all they want and drive the value up beyond the hard assets due to those intangibles. But truthfully those stocks are possibly overvalued. So what does “fair value” write up of hard assets do? Does it come from the complimentary value embedded in management or does it drive the stock price up even further? So, really, it comes down to the fact that everyday speculation has built in problems of possible overvaluation, keeping the hard assets to historical costs acts a suppressor to runaway overvaluation.
As for getting taxes from write up, I certainly will stand corrected, but tax has the concept of basis, or the historical cost paid, that will remain with the asset until it is disposed of. So taxes will remain, as far as I know, on an historical cost basis and the book write ups will be a book to tax adjustment for tax purposes.
There always has been room for fair valuation. It just shouldn’t be part of GAAP statements. Speculators need to do their own speculation and spend THEIR time on due diligence above and beyond what accountants and auditors can conceivably do. If there is going to be a massive loaning of money, or a huge stake made from an equity position, then I’d hope that current, up to date assessments are made as to values. But to make accountants ultimately speculators in the first instance merely puts them on a hotseat not of their own making.
And since I’ve spent all this time and long wind again, people need to understand that there are no precise methods of valuation. You can get a plethora of values for the same thing depending on how it is formulated, and they can be substantially different. Tossing out “fair value” like it is some sort of concrete concept is another in a long line of misconceptons. In practicality, auditors will be faced with three separate valuations and they will pick the middle one, to cover their ass. Not too high to be sued on the one side, and not too low to be sued or discharged on the other.
The mad dash to fair value needs to include the concept that interim statements aren’t likely to have fresh fair values made. So the further one is from the previous valuation the more they should make a valuation on or about the time they plan on putting cash on the barrel head. In other words even values on interims are as good as the previous year end. And the indoctrinator of my oft referred to seminar said that fair value is a process that works in NORMAL ENVIRONMENTS anyway. And most problems in valuation occurs in NON-NORMAL environments. So the end result is simply replacing one form for another that, in normal times, likely would require a reevaluation if a massive transaction were going to be taking place, and isn’t any more worthy in a time of massive ups and downs. It simply is going to be another inexact method that happens to require more on-going bureaucratic support to maintain it. Perhaps historical cost (or lower of cost or market) served three purposes – it was objective, it was conservative, and it was simpler to maintain, with the understanding that any judicious person would make a thorough vetting of the assets (and liabilities) at a specific natural time and place, not an ongoing cascade of speculation.
In the end, we’ve had historical cost/asset impairment with MtM for exchange based assets up until now. Anyone want to tell me that it was unsuitable as we’ve seen the Dow go from 14100 to 7968 in about a year (with a soft bottom under us)? Where in the hell would stock have been at if we had had fair value accounting and the stock market was inflated even more?
In a nut shell, accountants shouldn’t be part and parcel of the creation of bubbles. We need to report conservatively on an ongoing basis, and assist people in trying to find a reasonable value when circumstances necessitate it. Simply being the tote keepers of a over-speculation run-up isn’t much of a profession.
The point of view of jesus huerta de soto calls into question the whole legitimacy of the valuation of assets by the market. Not only it is an open door to the anti-market position but it is also wrong. The accounting rules based on mark to market accounting are not responsible of the crisis, the human action yes. The mark to market accounting is only responsible to inform the market that things go well or wrong, better or worse, and what the asset value is, according to buyers and sellers, that’s all. The subprime crisis is not virtual. It is not created by unreal or underestimated book values as long as these reflect what the market really thinks. Jesus huerta de soto should ask yourself : if everybody thinks that the true value of an asset is higher than the market says at a given date why the price do not go up. Probably because those who say this do not really want to pay this price but hope that others do or that a change of accounting rules will save them from bankruptcy! I had my eyes open wide when reading that “the only truly objective criterion is that of historical cost”. Historical cost is only true when you buy the asset and it is the market price at this time, but It no longer makes sense after a while. Is the human action objective? Is the value objective? No sense. The value of any asset is always given by a free agreement between buyers and sellers at time it is concluded. If not, the asset does not sell. And the finality of any private economic activity is to sell. Those who incriminate the mark to market rule are subject to the messenger syndrome which is the act of killing the messenger, who brings the bad news. Breaking the thermometer does not bring the fever down. The aggravating factors of this crisis are rather prudential rules and undercapitalisation (both are related to each other) in banking which have undermined the confidence in the strength of the banking system and have driven investors to sell even at a loss.
Peter has bought a stock on March the 27th at a unit price of $100. John has bought the same stock one month later at a unit price of $115. Assume that both record their purchase in their account book at historical cost. If the only objective criterion to valuate an asset, the only one which reflects the true value of this asset, according to Jesus huerta de soto, is the historical cost, how can it be explained that there can be numerous different true values for the same asset?
fair — to whom?
It’s just progressing towards the point of no return….
I think with all this talk about M to M, Mr de sotos point is the prudence concept…..which (used to) require that an asset that appreciates on percieved/estimated/mark to market value must still only be held and accounted for at HISTORICAL cost until such time as it is sold – on the simple grounds that a profit hasnt been made uintil that sale takes place. SO the profit is only booked at that point. Conversely, where the asset depreciates on estimated/percieved/mark to market measures, the potential loss is booked as soon as the deterioration is seen.
That’s prudence, and it makes a lot of sense in accounting – You can count your eggs by all means, but you dont count the chickens until they hatch. And it is insane to continue counting eggs that are broken on the technical grounds that they havent hatched yet.
Sorry I neglected to show that my last post was a response to Lionel’s query about Peter and John.
May I add that there IS no true value other than that crystallised at the moment of sale, and that only remained true for an instant. so from the perspective of Peter or John, the price he paid for it is the only meaningfull anchor for his carrying value, subject to the prudence-driven asymmetry that requires APPARENT, or LIKELY appreciation to be ignored, and apparent or likely deterioration to be accounted for.
Sorry I neglected to show that my last post was a response to Lionel’s query about Peter and John.
May I add that there IS no true value other than that crystallised at the moment of sale, and that only remained true for an instant. so from the perspective of Peter or John, the price he paid for it is the only meaningfull anchor for his carrying value, subject to the prudence-driven asymmetry that requires APPARENT, or LIKELY appreciation to be ignored, and apparent or likely deterioration to be accounted for.
central government planner here
This is one of the few posts that I wholly agree with.
But, you know me.
It’s currency is not to just rail against M2M, but to point out how it has been used on the way up, contributing to pro-cyclical diseconomies.
Restoring the original cost accounting methods will wipe out a whole lot of self-created wealth, and render worthless all those multi-tiered bets that things WILL work out.
This is an excellent course on why we need to change cost-accounting methods, hopefully we can also figure out how the transition can be fairly exercised.
Matthew,
You are right, in accounting you should remain consistant, whether it is mark to market, LIFO or FIFO. You just can’t mix them to fit your needs.
But mark to market on the upside overstates values that allow firms to over speculate causing prices to increase beyond the market. On the other sided, the lower mark to market causes prices to fall as forced liquidation pushes prices below the market. Each situation has its evils and as far as I can see, no benefits.
To show you the effects in the market, look at the action in the stock market today. We were down 100 points and news came out that Congress is looking to shelve mark to market and the Dow shot up to be up over 100 points. This tells me that the markets feel that mark to market understates values today.
I would like to give an example of how MTM is a fallacy. I know of a plant in Chile, with a sawmill, dry kilns, cogen biomass energy center, and secondary processing plant. It was valued at xx million. They were forced into default by their bank. The bank took the assets, and attempted to sell the entire facility. They advertised it to many potential buyers in many countries, but no one was interested in buying. They then decided to liquidate it piecemeal through auction. They set up the auction and advertised it, and on the day of the auction NO ONE came. No one had any interest in any of the assets. Shocked they regrouped and tried again, advertising far and wide through out all of SA. They held the second auction and surprise! no one showed up.
So the book value was xx million. The NPV of the expected future cash flow was zero. The value of it in an open market sale was zero. The value of it at liquidation was zero.
What value should the bank place on this asset? They should value it at zero. That is a reasonable application of MTM.
About 1/4 mile from this mill is another similar, though larger complex. Same basic operation, just larger in capacity. It is still operating, generating cash flow. Under the principles of MTM, the market value of this kind of operation in this location, processing these kinds of logs, and making this kind of finished products is ZERO, especially if the bank wrote down the value of their asset. So the company operating the facility that is generating positive cash should write down their asset to ZERO under MTM. That is absurd.
Now the company has 20 other similar complexes on their balance sheet. Since you have one complex you have been forced to write down to zero, because of MTM requirements, should you not also be forced to write each and every other one of those other assets to ZERO? That would be 20 complexes with a net asset value of perhaps $700 million to $1 billion marked to zero. If that was to happen then the company would lose $1 billion in assets, and also $1 billion in equity. In all reality they would be functionally insolvent, and the bank would then be able to force them into default, even though they are profitable, and are generating net positive cash in excess of their debt requirements. That is arbitrary and absurd.
Good stuff on accounting. Lower of cost or market is what I was taught years ago and it sure served the world well for a long time. There is no place this measure is more important than financials, where capital is leveraged and a temporary invention of appreciation to fatten the perceived capital reserves blows up in the faces of many. Marking to market has been the rule for decades as long as market was below cost, mainly because it forced those presenting the figures to acknowledge the facts, as not to surprise those relying on the figures. It appears that doing honest business was a thing of the past and the more smoke and mirrors one could come up with, like SIV’s and the Enron game developed by the banks and apparently an accounting firm. The only thing honest in the credit machine is having capital and when capital is invented on balance sheets in order to extend more credit, all goes away. The games I have read about since this mess started, like booking several years of interest income in advance as long as the mono-lines held their ratings and other nonsense just amazed me and was clearly one of the main components in this financial bubble. Anyone using prudent financial analysis could see the stock market was 100% overpriced at a minimum at its last peak and anyone that could see that knows there is a lot of lying about how cheap it is now. There aren’t any valid financial figures any more and earnings are in peril for years to come.
Many thanks to Professor De Soto for this really informative article.
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