Working For a Living

So, it is time to make my central point about accounting: The more work that the accountants do, the less work that the user has to do.

Accountants could just give investors the raw books and records. (As discussed in an earlier post, modern computers probably could handle this info if in a standard format, but something still would be missing: analysis by those familiar with the day-to-day of the business) Accountants analyze, compress, and format all this information so as to make it usable by investors and other consumers of financial information. It is work hard making a lot of data tell the kind of story that the users need. Business managers do not want to pay for this hard work. Unfortunately for them, their bosses, the shareholders, need for this work to be done in order for them to be able to police management’s stewardship effectively.

Unaccountable accountants below!

To be useful, accounting must be comparable across companies. If 2 otherwise-similar firms use different accounting rules, it is hard to figure which is better run and which is the better investment. Yet accountants want fewer and less detailed rules. Of course, detailed rules can be arbitrary. But, the accountants do not argue that current accounting principles are arbitrary. No, the accountants argue, the current rules are just too hard to work with. Trust an accountant’s judgment rather than make-work rules. But, it is unlikely that accountants across the country will exercise their judgment in a uniform a fashion in the absence of detailed guidance. In the current debate, simplification is the enemy of comparability — and therefor is the enemy of usefulness.

Tomorrow: Accounting rules and Enron’s shell entities.

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7 Responses to Working For a Living

  1. Boelf says:

    If we were talking science instead of accounting we would be talking peer review. As long as that process is followed I can have confidence that the science which is well beyond my capability to verify is still valid.

    I would think that in accounting we should of course have the analysis by the company accountants. But also provide the supporting detail so that peers have the capacity to challenge the analysis.

  2. GeorgeMundstock says:

    Boelf: I agree completely. A key role that the footnotes to the financial statements is supposed to play is to be where the accountants explain how non-number facts influenced their analysis. In fact, the principal role of the footnotes is to be where accountants hide stuff hoping that the markets miss it. Enron had a pretty scarry, if incoherent, footnote about the Fastow deals that nobody except shortsellers read apparently.

  3. Adam says:

    I understand what you’re trying to do, but what worries me is that a farm isn’t the same business as say a retail store or an airline or a software company. The European ‘accounting principles’ approach is a good one. By starting from broad principles that must be followed, they reduce the amount of gaming of the system that can take place, and that’s a worthwhile goal.

    The other thing that I think would be more useful than changing how companies report their finances would be to eliminate taxes on dividends. Allow me to explain. There’s two broad ways to value a business: the first is what you’d pay for its expected stream of dividends, the second is what it would cost to build that business from scratch. If we take the first one, then the taxation of dividends is distorting to incentives because it means that I have to pay tax each time I get a dividend. In contrast, I can choose when to sell shares of a company that’s using that dividend stream to buy back their own shares. Those share buybacks are a hack around the dividend tax.

    If we eliminate the dividend tax, then companies can signal their financial health by giving cash to shareholders.

    The usual argument against this is that it’s regressive, taxing the rich less. If that’s the concern, it might be possible to not tax dividends when re-invested, or to only tax exempt the first N thousand dollars of dividends. (I prefer the re-investment idea, but it generates a lot of paperwork.)

  4. GeorgeMundstock says:

    Adam: The European rules are not that different from ours. Evey paper that I have read concludes that the evidence is that investors trust European financials less than US.

    The taxation of dividends is way tricky. Remember that dividends are now taxed at capital gains rates, which apparently has reduced buybacks somewhat, but not as much as tax factors alone would suggest. The problem is that it is not clear how prices and the like adjust because of the dividend tax. In other words, nobody really knows who bears income taxes on dividends. Thus, it is not clear if repealing the tax really is regressive. For a discussion of all of the relevant theories, you may wish to read my “Taxation of Intercorporate Dividends Under an Unintegrated Regime,” 46 TAX L. REV. 101 (1989). Sorry, but I do not own the copyright and do not have a free link. In the past, the US has exempted a limited dollar amount of dividends from taxation. Canada exempts some gains on stock in Canadian companies if reinvested in stock of Canadian companies.

  5. Adam says:

    George,

    I don’t think that cap. gains and dividends being taxed at the same rate (temporarily, if I recall?) actually makes them interchangable. All other things being equal, I can choose when to pay capital gains taxes, but not dividend taxes. That inability to plan imposes a discount. (Or am I misunderstanding your “not as much as tax factors alone would suggest?”)

    I’m perfectly willing to accept that the social impacts of dividend taxes are hard to assess.

  6. Flush says:

    “The more work that the accountants do, the less work that the user has to do.”

    I have not read some of the prior postings on this blog, but I’m not sure that this statement holds. In fact I think the opposite can be said, because there are a number of different audiences that consume financial data.

    Maybe things have changed, but someone once told me about Four Sets of Books. One for Investors, one for the IRS, one for investment bankers, and one for executives.

    Ultimately, the executives hold all the cards and really only share all the books with select investment bankers, who help the executive extract rents for a fee (Enron).

    I understand the logic behind simplicity and comparability, but when I only have one-fourth of the picture, I’ll invest elsewhere (with back-dated options and all).

    Of course, I’m bitter.

  7. GeorgeMundstock says:

    Adam: But, from the point of view of corporate finance, both the dividend tax and the tax on share buybacks are elective, as mangement controls whether to distribute cash to shareholders (either way) and when. That is a big reason why it is so hard to model who bears these taxes.

    Flush: You are right. I worded that badly. As you point out, a lot of work by the accountants does not help the investors. But a lot of work by the accountants is needed if the financial statements are going to be useful to investors — or, at least, to their advisors.

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