I have been arguing that investors need more than just raw financial data. (Of course, CEOs like rah, rah data…) Investors also need financial statements that analyze, organize, and compress all of this information. But, I am not arguing that we should let accountants do all of the valuation work. That is “mark-to-market” accounting, which was the most important factor in Enron’s problems. [Haters of early 1990s pop music insert Funky Bunch jokes here.]
Under mark-to-market accounting, all of a business’ assets (and liabilities) are revalued (“marked”) to fair market value. Any increase (decrease) in the net value is added to (subtracted from) any profit distributions to shareholders (like dividends and share buybacks) in determining the business’ profit or loss. (Adjustments also are made for share issuances and the like.)
In theory, mark-to-market gives investors the most useful information, since it presents management’s stewardship of all of the busines’ resources, not just of financial transactions. In reality, however, matters are much different.
Reality is in the footnote.
I want to supplement prior discussion at two points: First, Michael was kind enough to email me from the ether to call my attention to a post 2 days ago on Brad DeLong’s blog, at DeLong Post He discusses an experiment that tested smart people’s ability to make simple investment decisions. They do not do well. An article quoted concludes that most people cannot be trusted to invest their own money and should hire investment advisors. If so, one legal regime would require small investors to use an advisor, as current law does (or at least used to when I did these deals in practice) if they want to buy a private placement. Then, accountings could be written for investment advisors. Accounting reform still would be needed, as everybody getting snookered by Enron suggests.
My pet gripe in the whole accounting simplification debate is how business and the accounting industry citie Enron as evidence that we need less detailed rules. They argue that detailed rules provide a roadmap for technical compliance that violates the spirit of the rules. In contrast, simple rules could not be gamed. In fact, Enron demonstrates the need for detailed rules.
Enron is best known for its use of Special Purpose Entities (SPEs) to manipulate accounting results. Enron would own most of a subsidiary corporation or partnership, but outsiders would have voting control, so that the entity would not be treated as part of Enron on its (consolidated) financial statements. Practice at the time was that outside investors put up at least 3% of the equity capital. In fact, in many of the Fastow/Enron deals, outsiders did not, and would not, put up 3% because the deals were so screwy. Clear rules worked. (Substantive accounting rules cannnot stop fraud.) End of story.
But, argues business, the 3% was so tempting that it encouraged the deals. Rather, if the rules left the separateness decision to the accountant’s judgment, she would have stopped these deals. Wrong! Details below.
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!
After much backing and filling, it is time to get serious about talking about financial statements that the average investor can understand — simplified accounting. This is not what an accountant means when she talks about simplification, however. To her, simplification is anything that makes her life easier: particularly, fewer and less detailed rules. In almost every case, the two views of simplification are at war. That will be the topic tomorrow.
There is one, easy first step toward real simplification: standardization of the form of financial statements. Today, no 2 companies’ financial statements look alike. The statements themselves have different names. Microsoft’s “balance sheet” is GE’s “statement of financial position.” Also, the items are presented differently using different language. Microsoft’s balance sheet shows 12 types of asset. GE, which is a much more complicated empire, has only 11. (GE’s “other assets” are almost twice the size of their property, plant, and equipment.)
More in the footnote.
Yesterday, I wrote about how companies are measuring customer satisfaction. This is an example of the variety of useful information that investors might find helpful that are not required to be collected and disclosed today. Another example is new metrics that quantify the success of a company’s development of technology (research and development and all that goes with them). And so on.
Which gets me back to my discussion about a week ago of the goal of financial disclosure, which is to help investors value stocks and bonds. These newer metrics are not measured in dollars. There is no precise way to use this information in valuing a company. (As compared to, say, accounting earnings; which can be converted into a value of a company just by multiplying by them by an average of the price-earnings ratios of similar companies.)
Nothing below. Don’t look….