Yves here. Please note that I’ve re-headlined Richard Murphy’s post, since he did himself a disservice by making it anodyne and thus greatly underplaying the important issue he raises. In addition, I am aware that Shakespeare’s “First, let’s kill all the lawyers,” which is widely treated as a disparagement of the profession, is actually a vote of support for their role. From Miller Samuel:
Perhaps one of the most misused phrases in the history of literature is the reference to a quote in Shakespeare’s play “Henry VI”, “First lets kill all the lawyers.”
The line is from The Second Part of Henry VI, act IV, scene ii, line 86; spoken by Dick the butcher, a follower of Jack Cade of Ashford, a common bully who tries to start a rebellion on which the Yorks can later capitalize to seize the throne from Henry.
The plan would be to take away the rights of common citizens but that would only work if they “killed all the lawyers.”
Nevertheless, the popular misconstruction is so evocative that it’s hard not to use it.
The points that Murphy raises about the extent and significance of misvaluation is particularly pressing in the financial services industry, where the double-entry-bookkeeping methodology of accounting does not map at all well onto instruments that have a lot of optionality. From a seminal 2010 post by Steve Waldman, Capital can’t be measured, that I strongly urge you to read in full:
Bank capital cannot be measured. Think about that until you really get it. “Large complex financial institutions” report leverage ratios and “tier one” capital and all kinds of aromatic stuff. But those numbers are meaningless. For any large complex financial institution levered at the House-proposed limit of 15×, a reasonable confidence interval surrounding its estimate of bank capital would be greater than 100% of the reported value. In English, we cannot distinguish “well capitalized” from insolvent banks, even in good times, and regardless of their formal statements.
Lehman is a case-in-point. On September 10, 2008, Lehman reported 11% “tier one” capital and very conservative “net leverage“. On September
2515, 2008, Lehman declared bankruptcy. Despite reported shareholder’s equity of $28.4B just prior to the bankruptcy, the net worth of the holding company in liquidation is estimated to be anywhere from negative $20B to $130B, implying a swing in value of between $50B and $160B. That is shocking. For an industrial firm, one expects liquidation value to be much less than “going concern” value, because fixed capital intended for a particular production process cannot easily be repurposed and has to be taken apart and sold for scrap. But the assets of a financial holding company are business units and financial positions, which can be sold if they are have value. Yes, liquidation hits intangible “franchise” value and reputation, but those assets are mostly excluded from bank balance sheets, and they are certainly excluded from “tier one” capital calculations. The orderly liquidation of a well-capitalized financial holding company ought to yield something close to tangible net worth, which for Lehman would have been about $24B….In other words, the definitive legal account of the Lehman bankruptcy has concluded that while executives may have shaded things a bit, from the perspective of what is actionable within the law, Lehman’s valuations were legally indistinguishable from accurate. Yet, the estimate of net worth computed from these valuations turned out to be off by 200% or more….
So, for large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded. Given these facts, and I think they are facts, even “hard” capital and leverage restraints are unlikely to prevent misbehavior. Can anything be done about this? Are we doomed to some post-modern quantum mechanical nightmare wherein “Schrödinger’s Banks” are simultaneously alive and dead until some politically-shaped measurement by a regulator forces a collapse of the superposition of states into hunky-doriness?
Now to Richard Murphy’s post.
By Richard Murphy, a chartered accountant and a political economist. He has been described by the Guardian newspaper as an “anti-poverty campaigner and tax expert”. He is Professor of Practice in International Political Economy at City University, London and Director of Tax Research UK. He is a non-executive director of Cambridge Econometrics. He is a member of the Progressive Economy Forum. Originally published at Tax Research UK
I suggested yesterday that the failures in auditing at PWC might be systemic, even though (inevitably) the Financial Reporting Council did not test that hypothesis.
Today I want to go a little further and suggest that the failure in accounting is systemic. My suggestion is that accountancy has been complicit in the valuation of things that simply do not exist.
One of the accusations against PWC was that they had signed off accounts which stated assets to have worth which was simply not in existence. So, an investment was stated to be worth more than £200 million when in fact it was worth, at most, £1. There were other examples. But the issue is not specific to BHS and the companies associated with it. The problem is systemic.
Accountancy is riddled with intangible assets. And arbitrary valuations. I’m not seeking to get too technical here. What I am referring to are four basic categories of assets. Being more specific does not help the argument.
The first such asset is goodwill. This is the excess value paid when acquiring a business over the sum that can be attributed to tangible, physical assets that can be valued in their own right.
The second group of assets are legally constructed property rights. These are things like patents and copyrights that only have value by presuming there is a future income stream.
The third are those supposedly marketable assets that apparently generate an income but for which there is no current market and to which a value is attributed on a ‘mark to market’ basis using models that might be as accurate as a forecast that it will snow in the UK today.
And finally are assets created intra-group. These are investments, loans and liabilities created in an intense web of transactions that are in themselves likely to be largely commercially meaningless but which leave a trail of interdependencies that render the accounts that include them largely incomprehensible in themselves, but which are nonetheless declared to be true and fair.
You can argue there are more or fewer such groupings. You can discuss which is more or less esoteric. I have problems with them whichever way you address the issue. The problems are, essentially, twofold.
The first is that these assets may simply not exist. Indeed, in isolation, they do not. So, goodwill is not independent of the underlying entity; intra-group debt is only of worth if the whole group might be, but not even then necessarily, and copyright only has worth as long as the property it relates to is still seen, heard or read. So the fact that someone once paid for these things is proof of nothing more than potential misjudgement at some time in the past. Too often that is now proving to be true. Not always, I stress. But too often. Which suggests that unquestioning acceptance of valuations based on pure history or models is failing accountancy.
And second? The problem is in the income statement. We recognise income from these assets in many cases (intra-group debt often excepted). But when we do we do not apparently think it appropriate to recognise that in most cases we bought that income. In other words, goodwill simply represents a purchased income stream. And an acquired copyright had a cost to buying the future income. And I think it should be mandatory that the cost in question be written off against the income. In fact, it should be written off even when there is no or little income. But accountancy is far too lax on this now, albeit it once was not.
Accounts are riddled, in my opinion, with assets that do not exist because they are at best nothing more than purchased income streams whose cost should have been written off against that revenue. Or the assets are simply manufactured.
I am not suggesting there is never a reason to recognise these assets. There may be, albeit with an over-riding requirement of prudent valuation that is now entirely absent from accounting. But, and this is key, investors need to be vastly more aware of their existence so that they can appraise the risk in an entity. So too do auditors need to do that because, simple souls that they seem to be, they are apparently quite unable to appraise this risk at present even when it hits them in the face.
The need is for a test of resilience. That is, a measure of the durability of the company when all these assets are stripped from consideration. That’s a second balance sheet in effect. The directors would, of course, be wholly at liberty to say why they thought this misrepresented the position of the company: I would have no difficulty with that, as long as they were personally liable for their claims. And then the investor can decide. Do they want the accounting hubris, or not? Some fundamental accounting might do no harm.
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Excellent post Yves. I especially enjoyed Richard Murphy’s clear and refreshing writing style.
Accountancy fundamentally depends upon accuracy and precision. I’ve never understood how one can accurately value certain intangibles such as Goodwill.
Nonetheless the Accountants will have to stand in line; there are a lot of groups that would be pitchforked first.
The Lehman situation is exactly and perfectly explained in the voluminous report called the Anton Valukis report (Mr. Valukis is or was a top notch bank examiner), and Lehman was hiding billions in debt within one or more hedge funds.
Surely Cade was for upsetting the system and giving poor men a chance? The law was on the side of the rich – so nothing new there then?
Cade outlines his plan for when he becomes benevolent dictator (“there shall be no money”), and Dick the Butcher is the one who delivers the line in response.
begob: Thanks. I’ve always been leery of the interpretation of the line as support of lawyers, considering that common folk wouldn’t have had access to lawyers in England of late medieval / early Renaissance times.
Also, it usually lawyers who interpret the line as being pro-lawyer. Lawyers also make up an unusually large part of the group trying to prove the Shakespeare of Stratford is “really” the Duke of South Billing and North Torts.
Nevertheless, the main post is fascinating for getting one thinking about the four main categories of intangible assets and how imaginary they are. And for voting one’s proxy against the accountants listed by corporations–accounting companies that oftern are associated and embedded for years and years. And the discussion of the income statement and its fictitiousness and uselessness is helpful: Writing these assets off would change many an annual report.
I was put in mind of Queen Mab:
MERCUTIO
She is the fairies’ midwife, and she comes
In shape no bigger than an agate stone
On the forefinger of an alderman,
Drawn with a team of little atomi
Over men’s noses as they lie asleep
“Everybody hates lawyers till they need one.” RSD or from me as regards attorneys. About 4 attorneys have been in my life. One may have saved my life as I kept getting calls any time of the day. I didn’t know what to say. I became depressed. He took art as his pay.
I tell youths they need from the first paycheck an accountant and an attorney & will so for the entireties of their lives.
I thought well of the insights myself. “The System has been hard on me.”
Where a company is late in paying its bills do the accountants have any calculation of ill-will? Has that ever appeared on a balance sheet? If not, goodwill should never be counted an asset.
I don’t blame the accountants. It is the politicians who are to blame for allowing the wrongs which are obvious to anyone with a little knowledge of business practices to persist.
Perhaps it is time to re-think limited liability and take a sharp knife to it.
Pip-Pip
In double-entry accounting, credits and debits must equal. This is a device to ensure accuracy: if the debits and the credits aren’t equal, there is an error somewhere, in recording, in arithmetic, but somewhere. It is a check-sum, and the unit of measure is cash.
So, say I pay you $25 for your lemonade stand business. Say the table is worth $5, the chair, sign, ice, sugar, and lemons are worth $2 each and the pitcher is $1, (valued at the lower of cost or market, as best as can be determined*), so the actual stuff I am buying from you is worth, by best honest guess and accurate arithmetic, $16. But I gave you $25. To make *my* books balance, I have to account for the other $9.
From my point of view, it’s worth it to pay you that $9. People know you, they like your lemonade, they are in the habit of buying it, you have found suppliers for all your ingredients, you have a good corner, you are open times that you have found customers come by who are hot, thirsty, have a few minutes and the price of a glass of lemonade and you have established a price that people are willing to pay that (assuming I have done my due diligence and your stand actually makes a profit) will generate a profit. Those are time-consuming things, a lot of work that I won’t have to do. As long as I don’t screw up, I should be able to just continue doing just like you did and the $$ will continue to roll in.
The work you did to organize that lemonade stand is worth the $9 to me, and I expect to get it back as I make and sell lemonade to your (now my) customers. It is work and experimentation that I won’t have to do and it eliminates a lot of risk for me. Accountants call this money paid over and above the actual value of the assets (stuff) acquired, ‘goodwill’. I will apply it against my future earnings as an expense over the next few years. Eventually it will come to zero and I am making the business work on my own reputation, product, and organizational/business skills.
In answer to your question, yes, a business can actually have ‘illwill’, but it is not called that. In the first place, it would only show up when a business is sold (or liquidated), and it would simply be recorded as a loss on disposal. Again, it is a way to make the books ‘balance’.
So, using same example: If you sell your lemonade stand to me and your table is worth $15 on your books, your lemons, etc, came to another $20 and you say your pitcher is worth $100, total $135, when I buy your your lemonade stand for $25, then *you* record a loss of $110 (‘illwill’, if you like). Why would you sell to me for $25, when it’s worth $135, according to your reckoning? You are either really strapped for cash, need to unload for some reason (eg, got a real job, going to college or maybe jail), or you know that the $135 is BS* and $25 is the best you will get.
* asset valuation is where the bezzle can come in, which I believe is the point of this article. The old-school rule is lower of cost or market, but the new rules seem to allow ‘mark to make-believe’ in the cases of “complex” “financial engineering”, aka flimflam.
Very interesting, thought-provoking.
On a deep level of the political culture, there is resistance to a recognition that all returns to capital are the indirect result of an exercise of political power, made possible by strategic manipulation of property rights and other rules of the game. The mythos of economics insists on moral virtue as a causal element and wants to place value into the ontological being of a capital of things, a stock of capital, an inventory of hopefully tangible things that are valuable — inherently valuable as things, having value in the same way a thing might have mass or color or strength. But, the reality is that value is a construct of a social, political system and money is a language for writing fiction in which value is a plot element, a mcguffin to make a business plan interesting.
And, travelling as a man from Mars into this Alice-in-Wonderland world in order to testify as to the Objective Truth of what is inherently a fictional story, the Professional Accountant seeks a way to spin out a stilted fiction of his own, without imposing a personal judgment. The position of the Accountant reminds me a bit of the way professional journalists have pursued Objective Truth into the infamous view from nowhere, where views on the shape of the earth vary.
The deep optionality of financial instruments poses a challenge to would-be tellers of objective factual truth: where are the facts in a froth of counterfactual anticipation? The idea that markets reveal in behavior true value that salesmanship obscures runs into the non-existence of actual markets in a world in which price is administered or negotiated between entities guided by a common interest.
I think the “true” value of Lehman in an objective sense would be seeking the right answer to the wrong question. A favorable exercise of political power can make instruments whose cash flow value is itself an exercise of political power, valuable or not. The aggressive provision of liquidity is general purpose rescue for those whose business is the arbitrage of carry.
The right question, I expect, would concern itself with the social value of the deal: is the instrument valuable only in the event of a socially ruinous operation or resolution? Detection of the toxicity of toxic assets might be more practical than valuing them “objectively”.
Ay, valuation is firstly a philosophical problem, only secondarily a technical one.
Alas, the “git more stuff is good and I’ll hurt you if you disagree” philosophy is not terribly sustainable.
It’s been working well so far, for some definition of work.
And some definition of well.
Ontological, being the Total Truth of it aye?
Bill Gates has more money than the Federal Account of the US Government. I read that and am certain I have been over charged.
You are doing great with a product that is the standard standard in a duopoly. Buffet the investor owns a Train line in a food transport duopoly situation.
Accountancy of a Freight Train Line is way different than the most extreme Good Name values existing in Hollywood & then Publishing dependent on the name of the writer developed by them as seen in the career of Hemingway.
I love the image of the Accountant creating a story.
Ontological. Great word.
Wow. Nice. I’m humbled. Really like the “right answer/wrong question” formula.
So accounts, made by people who drive very nice cars in very nice suits from very nice houses to very nice buildings, iow having all the outward appearances of respectability, bear little real relationship to what the rest of us get away with calling reality? They’re just going through motions, but getting ever so paid doing it? And the motions they’re going through, getting so very paid, are making the rest of our lives living hells?
Is the whole bloody FIRE.gov sector just just making up numbers and trading them between themselves, then extorting the rest of us to pay up when it all so inevitably blows up? That’s nothing like the social contract I think is enforce.
B) Love that quantum mechanical question in the intro. Somewhere out here on the Web there’s an intro QM article or vid that reassures people that, despite the bizarre goings on down there, yes, we still can know things and take meaningful actions right here on the human level. But I still can’t remember where, sorry.
The point of social organization from above, is like enclosures. To seize control of public property (privatize), to gain present income from its use (rentier), to aggrandize the future rent (debt), to monetize things which have no monetary value thru markets which are increasingly esoteric (bitcoin). Basically banditry and fraud.
Ding! But you left out another couple of important points:
1.) socialize expenses — make others (society, public, ‘government’) shoulder as many costs as possible costs (monetary, environmental degradation, remediation, health, etc. etc.)
2.) guarantee revenues — coerce the government to require and/or pay for a many goods/services as possible (health care, car insurance, pharmaceuticals, 401K’s, education, military, etc. etc.) with minimal oversight re quality, quantity, need, or, actually, anything.
break up the big firms. there should be no such thing as transnational accounting-consulting firms. cry me a river about some mythical synergy.
I remember when it used to be the “Big 6” and grandpa tells me that before the Big 6 it used to be even a bigger number.
I’ve practiced public accounting in the US for more than 35 years. I assume the author’s views have been framed from the UK perspective. Even so, I’ve had similar thoughts about how the profession has evolved over the years.
“Accountancy is riddled with intangible assets. And arbitrary valuations.” From my perspective I totally agree there’s problem with valuations. That should be the focus. I’ll explain later.
“The first is that these assets may simply not exist.” Sorry I disagree. An asset can exist even if it has no value. Again, the real issue is asset valuation.
“The problem is in the income statement. We recognise income from these assets in many cases (intra-group debt often excepted). But when we do we do not apparently think it appropriate to recognise that in most cases we bought that income. In other words, goodwill simply represents a purchased income stream. And an acquired copyright had a cost to buying the future income. And I think it should be mandatory that the cost in question be written off against the income. In fact, it should be written off even when there is no or little income. But accountancy is far too lax on this now, albeit it once was not.” I agree this could be a viable alternative.
First of all, what’s being discussed is how financial statements should be prepared. The way it works in the US is that companies prepare the financials and engage audit firms (CPAs) to sign off on the reports. The auditor is required to perform and document various procedures that validate the information (or require changes), before signing off. The auditor is supposed to act as a check or balance against inappropriate financial reporting, along with the Board of Directors. And these days, financial reports may include significant and highly subjective asset valuations that can be virtually impossible to substantiate at any particular moment.
There is a tension that can arise between how the company expects to present its financial condition vs. the the CPA firm’s point of view after completion of work. Understanding of basic human nature and reading media articles about numerous past audit failures, one can conclude the process doesn’t always work very well.
Why is that?
1. The direction in which the accounting rule-making body has proceeded
2. Level of enforcement (or lack thereof)
The Financial Accounting Standards Board (FASB) is the accounting standards setting body in the US. So, if a firm performs audits, and expects to be able to issue a clean audit report, then it MUST be able to demonstrate that the financials are prepared in accordance with the standards issued by the FASB whether it agrees with those standards or not.
Over the past 3 or 4 decades the focus of the FASB standards has deliberately shifted from the income statement to the balance sheet. Most notably in decades past, all balance sheet items were valued at cost (subject to accumulated depreciation, amortization and few other reserve type accounts). But then things started to change. The first really significant change came about around 1990 when it was required for companies to recognize liabilities for defined pension plan commitments. The impact was a huge hit to equity at that time (think GM). IIRC, the thinking was that a company’s balance sheet liabilities should reflect current value for each commitment that it’s made.
The directional change continued when it became apparent that FASB was going to require that all assets and liabilities should eventually be reported at fair value. That process took more than two decades, but fair value reporting has now been baked in.
The problem I have as a CPA is that the valuation process is mostly an art. While the essence of accounting (as opposed to financial reporting) is pure science (e.g. assets = liabilities + equity, debits = credits, etc.), by hoisting fair value reporting requirements on the profession, FASB moved the financial reporting process itself towards being more art than science.
Auditors many times don’t have necessary skills, and so the need for valuation specialists, which reduces their own role to being nothing more than a middleman.
So that’s how we got here. What can be done?
1. Increase enforcement. This must come from the PCAOB, SEC & DOJ – no brainer
2. Get rid of the fair value requirements for financial reporting purposes.
FASB can require that all variables necessary that come into play for a particular valuation situation, should instead be disclosed in the footnotes. No longer report valuation fantasies on the balance sheet. And if anyone says it can’t be done because the number of potential variables may be infinite, then the appropriate response is “then how the eff could anyone possibly calculate a precise valuation number under those circumstances?” Further, valuation like beauty, is in the eye of the beholder. For example, a newbie looking to purchase an existing insurance agency may focus on the bottom line net income to determine valuation of a prospect, while an existing agency, with preexisting infrastructure already in place and looking to grow, would most likely focus on the top line revenue number. Financial statement users will determine fair value based upon their own unique way of filtering data, giving highest weight to those variables most important to them as individuals.
If you agree with the above, then its logical to conclude footnote disclosure of the variables as opposed to precise valuation numbers on the balance sheet, would be more appropriate. Bring the balance sheet FASB standards back to a cost basis focus. And probably a good idea to amortize all intangibles over an extended period of time as the author suggests. Side benefit of all this is that it would reduce the obfuscation of the income statement, as could also be implied from the author’s remarks.
Chances are this will never happen because it would force financial statement users to work harder and understand the dynamics(variables) laid out in the footnotes before making decisions. God forbid! Much easier to rely just on a number reported on a balance sheet even if it’s nonsense.
Also a former practicing CPA, I could not agree more with anon48. The only thing I would like to add is that, at its very best, given the absolute fact that accounting has always required some measure of judgment, the most beneficial aspect of a precise (scientific is the term anon48 uses) system of accounting is that it renders each entities financial statements as, at a minimum, comparable. It follows that the more “scientific”, the more comparable. My point is that financial statements are not only erroneous now as the author points out, but are so riddled with idiosyncracies, that they cannot be relied on to view any two companies financial statements on a comparative basis. So, it is not so much that various assets are not valued properly, but that they are valued inconsistently so that there is really no possibility to evaluate which of any two choices are relatively better off. During the first stage of my career, the equivalent of the Big Four accounting firms was the Big Eight. But more importantly, those Big Eight accounting firms were all, by law, general partnerships in which each and every partner had unlimited personal liability for any misstatements due to their negligence. Today they are corporations with limited liability as any other corporation. I will leave it to others to speculate if the house of cards we have now has anything to do with the change in individual partners’ liability that occurred sometime along the way. Today it’s heads I win, tails you lose for both the company and its auditors.
Your point about consistency is spot on…how can reliable analysis be performed on a consistent basis from one period to the next when the subjective valuation numbers change? Especially if the changes arise, not because of changes in the nature of underlying financial circumstances, but rather due to a change in the valuation specialist?
yep, the all powerful FASB, located in the third teeniest (area wise) US STATE, Connecticut (5th STATE in the Union and also infamous for Senator Prescott Bush and his Nazi Connections and profiteering), after second teeniest STATE, Rhode Island [1], and Delaware [2], the teeny weeniest state – infamous for: historic, and ongoing, outrageous US TAX EVASION by Delaware Incorporated (though not ever domiciled there) Multinational Corps.; Senator JoeBiden; and and domiciling the Corporation Trust Center™ of the evermore powerful, since 1892, now transnational CT Corp monopoly of registered agents™ originally founded in the fourth teeniest State (and third STATE in the Union) of New Jersey, in 1892).
[1] Thirteenth STATE in the Union, and Infamous for slavery being Rhode Island’s ‘number one financial activity’ from 1720 to 1807
[2] The first STATE in the Union, and no doubt never disconnected from those banks in London, Inc. just as all of those Big Four, have parentage tracing back to London Inc.
yep, as ‘they’ have said since forever, it’s the little things in life …
More on CT Corp.’s Delaware Corporation Trust Center (and this is just from Wikipedia™, just imagine what’s missing from it):
“The first is that these assets may simply not exist.” Sorry I disagree. An asset can exist even if it has no value. Again, the real issue is asset valuation.
Well, sometimes an asset just doesn’t exist. I think you are old enough to remember Billy Sol Estes?
“The need is for a test of resilience”…
Resilience toward what? A coming revolution that could have the fraudulent liars swinging from lampposts, or failure to compete with other productive systems that take into account the needs of the people on a larger scale and limit the damaging social externalities that are exploited relentlessly under the current order. This post has the tone of a tepid warning to “investors” to a coming storm or radical readjustment.
When one becomes a parasite on the social body and consciousness, the question must be asked if it is even possible for such entities to be arbiters of truth or interpreters of reality. They are so ensconced in their various macanations to extract value from the social body, that they fail to see or are unconcerned with the direction they are traveling and determining through their actions.
The merchants have assumed supreme social power. The values of leadership are different when one has to account for the well-being of the citizenry. Business leaders and investors are proving incapable of directing the State.
True and accurate accounting is the stuff of revolutions. Neoliberalism rose due to the exploitation of false accounting. The discontent sown by that action is reaching a crisis point, and the imaginary worth and value expressed by that action will be just another shock that the citizenry will have to overcome- or not.
Resiliency indeed.
Reading this interesting and disturbing article, I was reminded of one of E.F. Schumacher’s incisive observations, made in one of his three great works: Small is Beautiful, Guide for the Perplexed, or Good Work. As I remember, Schumacher was referring to the complex, computer-generated computations that so often guide our economic analysis, planning, and forecasts. It was his opinion that he could do as well, perhaps better, with some scribblings made with a pencil on the back of an envelope. His opinion was based upon the recognition that the initial input that went into these complicated calculations was often merely a matter of guesswork or unchallenged assumptions, and thus garbage in meant garbage out, no matter how “sophisticated” the formulas used to yield the results. Schumacher, being the great wordsmith that he was, coined a wonderful term for this process, which now permeates all things economic: “spurious verisimilitude.” This article made me consider that the entire field of accounting may be captured in that phrase.
Compared to “National Income Accounting,” business accounting, as described above, is a model of clarity and accuracy.
I do a fair amount of computer modelling for engineering. Computer modelling is very useful to identify patterns in complex situations that would be very difficult or impossible to determine using hand calculations. These help identify weak points, potential positive or negative feedback loops, and sensitivity to various inputs.
However, you always have to do simple hand calculations to help bound the solutions and make sure your results are realistic since different model algorithm formulation introduce their own assumptions which may or may not be correct for the scenario. Too often I have had to point out that model outputs were not physically possible based on the input data.
2008 clearly showed that the financial models had a very poor understanding of reality. It seemed like most financial institutions were Schrodinger’s Cat banks in the fall of 2008 where nobody knew who would survive. Often the survivors were the ones who could convince people like Buffet to infuse cash.
To paraphrase the old saw;
It’s hard to get a man to admit something that his paycheck requires he deny.
Accountants are besieged on every side by corrupt management who insist they find a way to present as reality, all the flimsy abstractions and obfuscations they have strung together to further the dual purposes of making themselves rich, and hiding what is is they are doing.
So, where as the classic situation used to be two sets of books, one portraying the truth, and the other ‘cooked‘ so as to fool the tax-man, the situation today is such that the ‘true‘ set of books doesn’t really exist, leaving many firms lost in a fog of lies, of their own creation.
We can’t deny this situation, George H. W. Bush clearly, and honestly described the problem when he dubbed Reagan’s economic policies as ‘Voodoo Economics’, the quasi-religious belief in a combination of tax-cuts, deregulation, and cuts to government spending that was supposed to result in wide-spread prosperity by spurring growth in the economy at the top, and an inevitable ‘trickle-down’ of that wealth to the rest of us.
The results of allowing corporate leadership do what ever they like, and account for those actions, and the economic results however they please, has led to the epidemic of control fraud that we have been barely enduring these last few decades.
IMHO, corporate governance worked as long as that first, true set of books existed, and the executives knew, and understood their ‘real‘ situation.
The accountant’s part in this story line is due to management being allowed to put a gun to their heads to make them drink the cool-ade.
Ultimately, the result of deregulation/regulatory capture has been management’s pathetic, and irrational belief if their own hype, and their ability to impose that world view on the rest of us.
Believing your own BS is a sure-fire recipe for disaster.
A solution to the auditors conflict of interest is to combine Tax Collecting and Auditing as part of the commons.
The Auditors are then public servants, not servants of the entities being audited.
Exactly!
And in which way are our overlords pushing?
They’re de-funding the IRS, which is impacting their ability to provide the auditing services of the people of the USA.
The commons is evaporating along with, and including the glaciers.
Yes, exactly, and just so, Chomsky himself has said he reads the Wall Street Journal because he expects them to be most interested in accuracy. Their interpretations are another matter.
We have a similar, and I kinda think, larger, problem. Who’s been keeping The One True Books during the last century-plus of manufacturing consent? There’s frightening little agreement as to where we are and how we got here. I turn to science but even that’s got its own infestations and perversions to deal with.
Wherever here may be, the Sixth Mass Extinction is bearing no wait, has caught us and is now overtaking. But news of that fact might as well be about a different planet altogether, for all the concerted and commensurate effort being taken.
Many company financial statements are unauditable. Particularly those of banks which hold derivatives. I do not think the PCAOB should exist. As it operates, it is just a Big Four cartel enforcer.
Decades ago, today’s Big Four CPA firms, which audit 97.5% of US-listed companies by market capitalization, were the Big Eight. What does the PCAOB do as a practical matter: beat up small CPA firms which audit 1.5% of US-listed registrants by market cap.
In 1976 Senator Lee Metcalf had a report prepared, “The Accounting Establishment” about problems with the then Big Eight firms. What has Uncle Sam done in the last 42 years to rectify them? Nothing. The Big Four are doing exactly what Uncle Sam wants.
As you have said many times, Yves Smith, “feature or bug”? Bad audits of financial institutions are a feature of the system, not a bug
Fascinating comments, especially from the accountants. Thanks.
It looks as though Elizabeth Warren may be on to something with her proposed legislation to reform corporations and boards. I suspect that she is already aware of the flimsiness of annual reports that are then rubberstamped by the board, which is captive to the CEO and mainly wants its own perks and stock options. The idea of independent director is a weak one, given what I have seen on boards like General Electric (don’t ask why I have GE stock, please) with its timeservers who have often presided over the failures of their own companies.
Trying to put a value on things that don’t really exist… it is so very human. And the opposite, denial of liabilities. A far more troubling turn of events might be the way externalized costs have been totally ignored. It’s like there are really two corporations when it comes to accounting. The good one and the bad one.
I worked in valuation for a Big 4 firm for 6 years, covering many of the largest companies mainly in Chicago & midwest over hundreds of valuations.
Regarding ‘goodwill’ accounting (i.e. purchase accounting, SFAS 141, or ASC 805)
We should first correct this statement in the article about goodwill, which may alleviate some of this confusion.
So goodwill is a necessary PLUG used when Company Big acquires Company Small for $1 million. They spent $1 million (subtract asset value) and so we need to add $1 million to balance out. We start with tangible assets like cash, receivables, inventory, real estate, etc. (call it $600k)
Whatever number is left is booked to intangible ($400k). The valuation professionals decide what is the ‘primary’ intangible asset, usually the customers (but maybe technology or trademarks). That gets valued at $300k using the cash flows (income) of the business. The remaining ($200k) is goodwill (assuming there is only 1 intangible).
In most cases the auditors and company want as little goodwill value as possible because non-goodwill assets are amortized most of the time. Good for audit because it’ll go away so no need to worry about it. Good for company because if the acquisition goes poorly there is a smaller hurdle to jump over to show that there should not be ‘impairment.’
Arguing about this process is pointless because it is *definitely* a good approach to decide the company is worth what it was just bought for at that snapshot in time. Company Small is not a commodity like a ton of wheat so there aren’t really any better data points.
That most acquisitions are an overpay is largely irrelevant. That is for the investors to signal via stock price, or future cash flows to show later.
The problem is the valuation that happens after the acquisition
After the acquisition, the Company Big’s goodwill is checked annually to see if it might be impaired. But it’s usually tested at the combined (Company Big + Company Small) level to the extent they are grouped together in something called a Reporting Unit (i.e. similar parts of the business). So we’ve switched the basis here but it’s by necessity since the Company Small doesn’t exist anymore. The company is VERY MOTIVATED to avoid goodwill impairment, which signals a bad business to the market. And that motivation will influence independence of audit & valuation.
How is goodwill manipulated after the fact?
Here is where companies sway Big 4 leadership to avoid impairment. For example Sears management was able to hold off the valuation team from declaring impairment for ~5 years because they were sophisticated.
In other cases strong audit teams aligned with valuation will take a stand and force the right outcome. Federal Mogul (hello Carl Ichan) tried to strongarm a no impairment and lost right away even after the CFO began his call with the valuation team by saying ‘we do not accept impairment at Federal Mogul under any circumstance.’ But it literally took the most senior leadership at the audit firm to make it happen plus disadvantageous accounting structure.
Valuation relies on company forecasts but gets to use stock price to tell the company what the sum of all reporting units (total company) is worth. Most of the manipulation by savvy management happens by artificially loading up the parts of the companies (Reporting Units) that have the most goodwill. Complicit audit or valuation teams can mess with the ratio of goodwill to total intangible value by nudging it up. That will help drive a ‘no impairment’ outcome as well.
I do think there are some reasonable fixes that can help. The valuation teams are not the audit teams and not directly motivated to side with management for these engagements, which generate a relatively small portion of the valuation group’s revenue (Channel 1 vs Channel 2 clients). We could even draft a roadmap by looking to other valuation niches like property tax.
Regarding Financial Institutions:
It’s a different set of fair value valuation procedures that work with derivatives than the ones that create and audit goodwill. Agree that this system is broken in the ways that have been outlined here. Consider other factors that haven’t been discussed via this anecdote from when I was working at Big 4 on the Lehman valuations in 2007.
The audit team at Big 4 wanted to assess derivatives on the Lehman Brothers balance sheet, including the infamous Repo 105 ones. The risk was obvious to everyone. They decided to reach out to our office in Chicago rather than the NY one because they thought it might ensure more independence. Great!
But the very complicated and interrelated nature of the instruments meant that only 3 people at our firm (nationally) could realistically model and assess these. The valuation quoted the audit team ~$300,000 in internal engagement size. This was about 10x normal because it’s a lot of time from the most expensive people in our group. You can’t just stick an analyst on this. The audit team didn’t want to either pass on or eat that expense so they said no. Valuation team says we will not comment on the values or risk factors (e.g. sensitivity analysis under different economic conditions) of these derivatives. They settled for a meaningless memo that said that the methodology used to value the derivatives done by management was standard but that we couldn’t speak to the individual derivative value or any assumptions. Total cost to audit team = $5,000.
Fixing the independence issues in accounting or valuation remains difficult but there are other approaches that can make some progress. Like doing financial institution valuation for asset types outside the framework of a corporate audit. And ultimately we can’t rely on audit to do the job of the (repealed) Glass–Steagall act separating commercial banks and investment banks.
“But the very complicated and interrelated nature of the instruments meant that only 3 people at our firm (nationally) could realistically model and assess these.”
Think about that for a moment: 3 people could realistically model…… not understand and and value.
Complexity for the sake of “risk management” when no one can possibly understand.
Let the genuis’s that think up this crap put their own money on the line.. Pure unadulterated BS masquerading as sophisticated business savy…
The basic idea for an accounting system is to know the accounts of a company and the truth of it.
You get fraudulent accounting when you have a decadent system (where fraud is the business model) like this:
1. auditors are complicit in ensuring truth is kept under wraps (you get to see what they want you to see)
2. the regulators look sideways, analysts and others who make a living by painting a picture (drawn from opaque accounts with no need to ferret out the truth) irrespective of facts
3. media hype (e.g. Tesla, Netflix) of companies that should not exist as they burn money which can be put to more productive use
4) regulators, central bankers and government who themselves regularly fudge things(mark-to-fantasy by putting agun to the head of FASB in Mar 2009, ZIRP/NIRP, QE at will) or paint a picture
5) no one goes to jail (meaning to say no one is responsible for bad decisions)
6) socialize losses and privatize profits
7) politicians who regularly play up to the gallery for votes and get voted
8) ban short-sellers who are the only guys with a skin in the game
9) central bankers who create a crisis and then using dubious means (under the pretext of saving a system of their own creation they regularly put savers, prudent people and retirees regularly under the bus and print money at will) they promote themselves and take credit for putting out the fire
10) Not to mention that the rating agencies got away scot-free in 2009
Accounting cannot be seen in isolation and cannot change on its own without structural changes in the existing system.
Will it happen is anybody’s guess. But without a structural change everything else is just band-aid. How do you solve a multi-dimensional problem with a unidirectional solution. First you need to accept the problem and then only can you understand and resolve it.
When it is better to paper over the problem or push the can down the road, who wants to face the truth and have the resoluteness to take the painful (most medicines are bitter for a reason) steps to solve it and improve the society.