Counting on Trouble (Part 1)

Is accounting part of the problem?

At its heart, accounting is an attempt to translate the economic reality of an enterprise into a set of standardized reports. Accounting’s high-point was captured in a statement by Larry Summers in 1999 while Deputy Treasury Secretary. He stated that General Accepted Accounting Principles were perhaps the most important financial innovation on the American landscape. Talk about overreach!

Accounting is in many ways a disaster. For example, accountants now mark much of a bank’s balance sheet to market. Perversely, this means that when a bank’s credit standing deteriorates—and its own bonds sell off—that becomes a gain on the income statement. Academic accountants want banks to be more like mutual funds, with frequent statements of the net market value of the enterprise. But they set up perverse incentives for executives to game the system in order to maximize their own returns.

In the name of transparency, GAAP gives enterprises various optional accounting treatments that make it easy to smooth income, create hidden reserves, and just plain hide relevant information. Auditors are powerless to stop determined managers from making two and two equal five—when you add back the deferred tax reserve, the deferred comp reserve, and prepaid expenses.

In the past several years we’ve seen solar companies (and executives) get rich by trading tax credits; wood processors go out of business when the subsidy for a pulp by-product was ended; and financial shenanigans at MF Global and Lehman be blessed with clean audits.

Accounting isn’t science, and it isn’t art. It’s a language subject to political and social pressures. GAAP is an equation, and only rarely does it truly balance. Pretending otherwise just makes things worse.

Douglas R. Tengdin, CFA
Chief Investment Officer
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