A Tale of Three Accounting Methods

MARKETS-EUROPE-STOCKS/FALL by artemuestra.Let’s talk about accounting. I’m a political philosopher, not an accountant, but philosophers engage with values and pricing in at least two ways: 

1. ARBITRAGE: Philosophy is a kind of arbitrage.

2. THE GOOD: Normative theories like those discussed in the study of ethics, aesthetics, and politics depend on an account of value, i.e. the Good, and its relationship to the Right, the Beautiful, and the Just. There’s probably also an underlying account of the Good in epistemology’s concern for the True and metaphysics’ concern with Being and other ‘first things.’

In general, political philosophers who read Marx have to understand at least basic theories of value in terms of use and exchange, but we must also take sides on issues like the efficient market thesis or the psychological biases and failings that render human beings less than perfectly rational. In other words, as my friend Mike likes to say, we need to have a theory of price. That raises some other concerns that are more particular to me:

3. GLOBAL INJUSTICE: If you’re interested in global finance as a tool of neocolonial exploitation, as I am, then you’ve got to keep track of how it is that nations at the core of the global economy manage to keep periphery countries from recovering and surpassing them.

4. METRICS: Accounting methods that measure productivity and growth miss a lot, while we currently lack good measures of Gross National Happiness or Human Flourishing. Every utilitarian has to have a theory of conversion between GDP and aggregate utility, right? Where else to start but with the problems inherent in any accounting standard? 

5. FAMILY: Finally, my dad is an accountant, and lately we’ve had a number of disagreements about the economy that involve accounting methods. You know things are bad when technical accounting methods no longer count as polite conversation. So I thought I’d take a stab at this question: what accounting method is best? As I said, I’m no accountant, so I welcome corrections.

Many investors blame an accounting technique called “Mark-to-Market” for the last six months of bank failures. These investors complain that some assets are being severely undervalued because the market for them has dried up, and thus losses are overstated: consider the market for subprime mortgages. Our fear and uncertainty may lead to severe undervaluations, and these valuations may ultimately become a self-fulfilling prophecy. As I shall argue, it’s not that simple: depending on the timeline, our fear and uncertainty can actually be the best considerations in a valuation.

It is axiomatic that the goal in accounting is Fair Value. Everyone agrees with this. The debate is what that means and how to regulate compliance. 

Fair Value inevitably entails objective and subjective factors, so most of the debate is over how to weigh these factors.

Objective factors include:

  • acquisition/production/distribution costs, replacement costs, or costs of close substitutes
  • actual utility at a given level of development of social productive capability
  • supply vs. demand
  • Subjective factors include:

  • risk characteristics
  • cost of capital
  • individually perceived utility
  • (Straight from Wikipedia.)

    The basic conflict is between Mark-to-Model, Historical Cost, and Mark-to-Market. If you allow the subjective factors to play a role in your valuations, you’re doing Mark-to-Model. If you choose to ignore present valuations in favor of historical and realized costs, perhaps amortized for age or maturity, then you’re doing Historical Cost. Otherwise, the assets a company owns are valued at their present market price or for more complicated instruments, by observing other features of the market, like the volatility index. That’s Mark-to-Market.

    Mark-to-Model tends to give a false sense of liquidity. It doesn’t matter if your model says an asset is worth $X, all that matters is whether you can sell it on the market for $X when the bills are due. On the other hand, you’re not selling everything you own every day… unless you’re forced to. Since publicly-traded companies tend to publish their findings but not their assumptions, Mark-to-Model can lead to fraud. Worse,  in times of severe volatility Mark-to-Model tends to look like ‘mark-to-myth’ or ‘mark-to-make-believe’ as the models of valuation depend on stable market conditions and assumptions that may no longer apply.

    Historical Cost (sometimes called Amortized Cost) accounting is simple but completely unrealistic.  By definition, it involve false valuations: too high in bear markets and too low in bull markets. No one cares what a company paid for an asset, only what it’s worth. The problem is that this is only sometimes what the asset can fetch on the open market at present prices. Sometimes an asset is more valuable in use than it is in exchange. While replacement costs (the cost of an asset that functions similiarly) mimic this use value, it is difficult to compare older assets bought in uninflated dollars to newer models with newer features, which must be acquired and put into use. Historical Cost is usually accounted with amortization, or discounts for age, but this is not always accurate:  for instance, Windows XP is cheaper to purchase, manage, and distribute than Windows Vista, but it’s also easier to use. Thus, an old copy of Windows XP bought in 2003 is still worth more than the closest contemporary substitute, but amortization would suggest the opposite.

    That leaves us with Mark-to-Market. It’s the Goldilocks valuation: not too hypothetical, not too concrete, but just right. It depends on current market prices to derive the cost of replacement, substitutes, and even actual utility. When supply outstrips demand, market valuations go down, and vice versa. This, too, is not without it’s pitfalls: Mark-to-Market is responsive to changing situations, but perhaps too responsive. It enables speculators to run up valuations or to run them down very quickly. But that’s not so bad: investors want to know what a company’s assets are worth both in the best and worst case scenarios, because that’s how they measure upside and downside, profits and risks. Moreover, we live in a global economy. Our investors are international, and ultimately we have to move to international accounting standards. Convergence between US and International Generally Accepted Accounting Practice (GAAP) is unavoidable, if we are to compare results between foreign businesses and domestic ones, and International GAAP is a Mark-to-Market standard: 

    the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.

    Basically, I’ve concluded that accounting changes are not the solution. Every method has its dangers, and switching from one to the other has begun to look a bit like jumping from the frying pan into the fire. Convergence with international GAAP is inevitable, and internationally, investors want some type of principle-based Mark-to-Market accounting. Mark-to-Market has the advantage of honesty, and since much of the credit crisis is a crisis in trust, we can’t move away from frank and full disclosure of profit/risk assessments at this crucial time.

    The SEC concluded much the same thing in December in its assessment of the bank failures. Here’s their response to criticisms of Mark-to-Market accounting

    [M]ost investors and other users of financial reports who provided input indicated a view that fair value accounting transparently reflects, under current economic conditions, the value of assets and liabilities of the companies in which they invest. Most indicate that suspending fair value accounting would result in a loss of information and investor confidence. However, these comments also clearly indicate that fair value reporting can pose challenges, particularly in the absence of active markets. Users also express the need to supplement fair value accounting with robust disclosure of the underlying assumptions and sensitivities, particularly when fair value estimates are necessary in the absence of quoted prices. […] Nonetheless, there is little evidence to suggest investors and other users generally believe an alternative to fair value, such as amortized cost, would be a superior approach.

    The biggest danger isn’t the accounting method, it’s leverage: when you borrow money to buy or sell an asset, your lenders will come looking for their money when that asset loses too much value. As such, the best way to understand current market conditions is as a great de-leveraging: financial insitutions, like consumers, have been overleveraged, and prices have responded to the increased liquidity as speculators unwind their positions and consumers adjust their budgets to reflect the new realities.

    The fact is, there’s less money hanging around then there used to be. Some of it is tied up in Treasury bonds, gold, and other conservative inflation hedges, but a lot of it has disappeared, as if it never existed. It was the product of speculation and fraud: counterfeit money, basically. We’re all going to have to come to terms with this: many of the things we bought with borrowed money are worth less than we paid for them. How do I know? The market says so.

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