Public Domain. Source: Life of Pix
I remember the first time I encountered a detailed balance sheet. I’d been hired to implement a new analytical system at a small bank, and I was looking at their internal accounts. “Oh, don’t look at that month,” I was told. Why? That month was a little special. The State where they were located gave the bank a special tax credit for holding US Treasury Notes on that month-end, and this small bank had purchased over a billion dollars in bonds – for just one day. That was real money, even back then.
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 when he was Deputy Treasury Secretary. He stated that General Accepted Accounting Principles (GAAP) were perhaps the most important financial innovation on the American landscape. Really? More important that Automatic Teller Machines?
Accounting is a disaster. For example, accountants now mark much of a bank’s balance sheet to market. Perversely, this means that when a bank gets in trouble and its credit standing deteriorates – causing its bonds to sell off – that becomes a gain on the income statement. Academics want banks to be like mutual funds, with daily statements of their net market value. In the process, they set up perverse incentives for management to game the system and maximize their own personal payout.
In the name of transparency, GAAP gives businesses 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 twelve – when you add back the deferred tax reserve, the deferred comp reserve, and prepaid expenses.
In the past few years we’ve solar companies have gotten rich by trading tax credits; wood processors go out of business when the subsidy for black liquor ends; and financial shenanigans at several big banks were blessed with clean audits, just before the banks failed.
Accounting isn’t science and it isn’t art, either. It’s a language, and it’s subject to all kinds of political and social pressures. GAAP is an equation, and it doesn’t balance. Pretending otherwise just makes things worse.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”