Accounting Reform Precipitates Financial Crisis

I just read a great article by one of my favorite Austrian economists, Jesus Huerta de Soto, explaining an aspect of the financial crisis that I never heard anyone point out. The government cannot be trusted with the money, the law or, apparently, accounting standards! I found the following article at Professor Huerta de Soto’s page “articles in English” on his website jesushuertadesoto.com. Here is the full text:

FINANCIAL CRISIS: THE FAILURE OF ACCOUNTING REFORM

Jesús Huerta de Soto
Professor of Political Economy, Universidad Rey Juan Carlos

The years of “irrational exuberance” which have characterized the current economic
cycle have culminated in a profound crisis in both the banking system and financial
markets, a crisis which threatens to trigger an acute, global economic recession. A
central feature of the recent period of artificial expansion was a gradual corruption, on
the American continent as well as in Europe, of the traditional principles of accounting
as practiced globally for centuries. To be specific, acceptance of the International
Accounting Standards (IAS) and their incorporation into law in different countries (in
Spain via the new General Accounting Plan, in effect as of January 1, 2008) have meant
the abandonment of the traditional principle of prudence and its replacement by the
principle of fair value in the assessment of the value of balance sheet assets, particularly
financial assets. In this abandonment of the traditional principle of prudence, a highly
influential role has been played by stock brokers, analysts, investment banks (which,
fortunately, are now on their way to extinction), and in general, all parties interested in
“inflating” book values in order to bring them closer to supposedly more “objective”
stock-market values, which in the past rose continually in an economic process of
financial euphoria. In fact, during the years of the “speculative bubble,” this process
was characterized by a feedback loop: rising stock-market values were immediately
entered into the books, and then such accounting entries were sought as justification for
further artificial increases in the prices of assets listed on the stock market.
In this wild race to abandon traditional accounting principles and replace them with
others more “in line with the times,” it became common to evaluate companies based on
unorthodox suppositions and purely subjective criteria which in the new standards
replace the only truly objective criterion (that of historical cost). Now, the collapse of
financial markets and economic agents’ widespread loss of faith in banks and their
accounting practices have revealed the serious error involved in yielding to the IAS and
their abandonment of traditional accounting principles based on prudence, the error of
indulging in the vices of “creative,” fair-value accounting.

It is in this context that we must view the recent measures taken in the United States and
the European Union to “soften” the impact of fair-value accounting for financial
institutions. This is a step in the right direction, but it falls short and is taken for the
wrong reasons. Indeed, those in charge at financial institutions are attempting to “shut
the barn door when the horse is bolting”; that is, when the dramatic fall in the value of
“toxic” or “illiquid” assets has endangered the solvency of their institutions. However,
these people were delighted with the new IAS during the preceding years of “irrational
exuberance,” in which increasing and excessive values in the stock and financial
markets graced their balance sheets with staggering figures corresponding to their own
profits and net worth, figures which in turn encouraged them to run risks with
practically no thought of danger. Hence, we see that the IAS act in a pro-cyclic manner
by heightening volatility and erroneously biasing business management: in times of
prosperity, they create a false “wealth effect” which prompts people to take
disproportionate risks; when, from one day to the next, the errors committed come to
light, the loss in the value of assets immediately decapitalizes companies, which are
obliged to sell assets and attempt to recapitalize at the worst moment, i.e. when assets
are worth the least and financial markets dry up. Clearly, accounting principles which,
like those of the IAS, have proven so disturbing must be abandoned as soon as possible,
and all of the accounting reforms recently enacted, specifically the Spanish one, which
came into effect January 1, must be reversed. This is so not only because these reforms
mean a dead end in a period of financial crisis and recession, but especially because it is
vital that in periods of prosperity we stick to the principle of prudence in valuation, a
principle which has shaped all accounting systems from the time of Luca Pacioli at the
beginning of the fifteenth century to the adoption of the false idol of the IAS.
In short, the greatest error of the accounting reform recently introduced worldwide is
that it scraps centuries of accounting experience and business management when it
replaces the prudence principle, as the highest ranking among all traditional accounting
principles, with the “fair value” principle, which is simply the introduction of the
volatile market value for an entire set of assets, particularly financial assets.
This Copernican turn is extremely harmful and threatens the very foundations of the
market economy for several reasons. First, to violate the traditional principle of
prudence and require that accounting entries reflect market values is to provoke,
depending upon the conditions of the economic cycle, an inflation of book values with
surpluses which have not materialized and which, in many cases, may never materialize.
The artificial “wealth effect” this can produce, especially during the boom phase of each
economic cycle, leads to the allocation of paper (or merely temporary) profits, the
acceptance of disproportionate risks, and in short, the commission of systematic
entrepreneurial errors and the consumption of the nation’s capital, to the detriment of its
healthy productive structure and its capacity for long-term growth.

Second, we must emphasize that the purpose of accounting is not to reflect supposed
“real” values (which in any case are subjective and which are determined and vary daily
in the corresponding markets) under the pretext of attaining a (poorly understood)
“accounting transparency.” Instead, the purpose of accounting is to permit the prudent
management of each company and to prevent capital consumption, by applying strict
standards of accounting conservatism (based on the prudence principle and the
recording of either historical cost or market value, whichever is less), standards which
ensure at all times that distributable profits come from a safe surplus which can be
distributed without in any way endangering the future viability and capitalization of the
company.

Third, we must bear in mind that market value is not an objective value: in the market
there are no equilibrium prices a third party can objectively determine. Quite the
opposite is true; market values arise from subjective assessments and fluctuate sharply,
and hence their use in accounting eliminates much of the clarity, certainty, and
information balance sheets contained in the past. Today, balance sheets have become
largely unintelligible and useless to economic agents. Furthermore, the volatility
inherent in market values, particularly over the economic cycle, robs accounting based
on the “new principles” of much of its potential as a guide for action for company
managers and leads them to systematically commit major errors in management.
Moreover, if this state of affairs is serious for a financial institution, it is much more so
for any of the small and medium-sized enterprises which make up 90 percent of the
industrial base.

Fourth, we must remember that the abolished accounting standards already stipulated
that in the additional notes of the annual report, stockholders be informed as of a certain
date of the market value of the largest assets, but this in no way affected the stability nor
the traditional principles of prudence demanded by any accounting assessment of the
different entries in the balance sheet. Furthermore, the accounting standards abolished
were prudent and anti-cyclic, and they allowed for provisions to cover all sorts of
contingencies, provisions sadly missing now.
Conclusion

Just as “war is too important to be left to the generals,” accounting is too vital for the
economy and everyone’s finances to have been left to the experts, whether they be
visionary professors, auditors eager to strengthen their position, analysts, (ex)
investment bankers, or any of the manifold international committees. All have been as
arrogant in the defense of their false science as they have been ignorant of their role as
mere sorcerer’s apprentices playing with a fire that has been on the verge of provoking
the most severe financial crisis to ravage the world since 1929.

Madrid, December 8, 2008

Gallery | This entry was posted in economics, financial crisis, Uncategorized. Bookmark the permalink.

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