ACCOUNTING REFORM

Feb 13, 2009 Editorial

Of recent, the developed countries, caught in their financial maelstrom, are reappraising the International Accounting Standards (IAS) that they, and so many other countries including Guyana, accepted recently.
The assessment of many is that the greatest error of the IAS reform is that it scrapped centuries of accounting experience and business management when it replaced 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.
We offer the following commentary of Jesus Huerta de Soto, in light of the recent comment by the Minister of Finance on the need for reform in the regulatory standards of our financial sector.
We believe that the reform must also go into the substantive banking and accounting rules that facilitates the high-flying behaviour and threatening the very foundations of the market economy for several reasons.
First, to violate the traditional principle of prudence, and to require that accounting entries reflect market values would be to provoke, depending upon the conditions of the economic cycle, an inflation of book values with surpluses that 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 emphasise 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 that ensure at all times that distributable profits come from a safe surplus that can be distributed without in any way endangering the future viability and capitalisation 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 that 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.
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.

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