Tuesday, December 11, 2018

The Keepers of Economic History

Typical Balance Sheet

 by Cherileigh Leavitt

The language of business: a fictional tale or a reliable report?  What do investors and businesses really want?

 The technological innovations of the Digital Age caused people to question and sometimes abandon traditional methods.  For example, CBS News released an article last year reporting that over fifty percent of U.S. households no longer used landlines and only had cellphone service.  Flash back just over a decade to 2004 and over ninety percent of U.S. households had landlines, but they’re now considered a “dying breed.”  Just as traditional systems have been challenged in the past, a traditional accounting system is being challenged today.  Assets and liabilities are traditionally reported at historical cost, but historical value also has a competitor: fair market value.



A Little Background

To understand the significance of reporting at historical value vs market value, we have to be familiar with the balance sheet.  The balance sheet is a financial statement that provides a “snapshot” view of the company’s financial position each quarter, and accountants are responsible for recording and reporting what goes on these statements.  If Disney bought the land in California for Disneyland for $879,000 in 1954, is that still the value of the land today?  No, of course not.  It’s probably worth several million dollars.  The historical value is the original price Disney paid for the land, and the market value is what it would be worth today.  So which value should be reported on the balance sheet?  Although market value reflects a more accurate present value of assets and liabilities, historical value offers an objective and reliable report by sticking to the facts, avoiding earning manipulation situations, and sidestepping the consequences of volatility.

The Keepers of Economic History or Fictional Forecasts?

At the heart of this debate is the question: what does the audience want?  Managers, shareholders, investors, banks, competitors, suppliers and many other users base personal and company-wide decisions off these financial reports.  Are they expecting a list of forecasts for future earnings or a report of objective numbers that reflect historical value?  Both figures are important and beneficial when making decisions. 

Many businesses report at market value because of its relevance.  Using historical cost, Disney’s balance sheet will report that it has an asset of land at a value of $879,000 when really, the land is worth much more.  Market value presents a current valuation so the business can gauge a clearer idea of their financial situation.  However, even with footnotes that explain how estimates were calculated, those numbers are still susceptible to changes in each industry and the overall economy.  Historical value provides a sound foundation for decision making that can’t be guaranteed by estimates. 
Historical Cost Vs. Market Value
While we might not know which value (historical or market) each individual wants to see on the financial statement, it’s likely he/she does want something credible, and because historical value is non-debatable, it provides a reliable report.
Charles Lee, a professor of accounting at Stanford graduate school of business argues, “The market has come to rely on accountants as the keepers of economic history…As an investor, when I turn to financial statements, I want a trustworthy and interpretable account of what took place.”  Accountants can insure the validity and credibility of the financial statements by reporting at historical value.  Lee goes on to say, “As soon as we start to anticipate future exchanges, we are in a world of speculation.  And unfortunately, given dysfunctional managerial incentives and other moral hazard problems, it is often a world of fiction.”

The Temptation of Manipulation

Now, this doesn’t mean that fair value reports are blatant lies.  All public companies have to follow international and national accounting principles and pass an audit when their financial statements are released.  However, just as public relation specialists have the role to present a corporation in a positive light, accountants and other managers feel the pressure to present their company in a profitable light.  And the mark-to-market method is an all-too easy and tempting option if things aren’t looking bright.

Estimating the market value of an asset is a difficult task because so many factors influence it.  Each person will tell you a different estimate, and you won’t know the real fair value of the asset until you sell it.  Sounds complicated, right?

Or convenient…

Accountants or managers can use this range of variance to manipulate valuations an reflect higher incomes.  In 1985, Enron Corporation, an energy and services company, emerged.  By 2000, their shares skyrocketed to a staggering amount of $90.56.  They were the seventh largest company in the United States with a worth of $70 billion.  But by the end of 2001, the company reported bankruptcy.  They’d experienced a loss of $618 million with a $1.2 billion value write off, and their stocks had plummeted to a pathetic $0.26 per share. 

Enron's Share Prices, 1984-2001
While a few different factors contributed to this scandal, mark-to-market accounting was the first step to a slippery slope of fraud and loss.  Each asset was reported at a value of its projected profits (at fair value), but when the economy fell in 2000, the company faced many losses.  Enron used its partner companies that it’d created to hide these losses and maintain good standings in the market.  Eventually the earnings manipulation came back to bite them. 



Most circumstances in which mark-to-market accounting is used don’t end up in outrageous scandals, it’s better to avoid the temptation altogether because it easily leads to more fraud.

More than the Sum of its Parts

Market values are constantly fluctuating which creates more work for businesses and less accuracy in the financial statements.  Accountants have to mark assets and liabilities up or down which each quarter, and these changes in valuation lead to “misleading gains or losses in the short-term picture” (Gjorgieva-Trajkovska).  By reporting at historical cost, companies avoid these misleading gains and losses and the extra steps required to record valuation.

In the Enron scandal above, if the market value of their assets had steadily increased (which is expected in a stable economy), then disregarding the other fraudulent activities, the company likely would have survived while using fair value accounting. 

However, Stanford’s Professor Lee gave a word to the wise when he cautioned, “A healthy company is worth more than the sum of its parts.”  Meaning, at whatever value the financial statements report a company, the market value should be higher.  By reporting at historical cost, businesses can nearly always insure that fair value will exceed the reported figures.

Conclusion

While fair value accounting is useful and relevant, accountants should report at historical cost to create objective and dependable financial statements and avoid keeping up with the volatility that can create misleading financial statements or lead to fraud.  If accountants provide the historical value, the other financial statement users can calculate their own estimates to determine market value.

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