Peeling away financial reporting issues one layer at a time

IASB: The Rules of Arithmetic Are Suspended Indefinitely

"The London Symphony played Beethoven last evening, and Beethoven lost." That quotation, which my father attributed to George Bernard Shaw, leapt into my mind as I read Marie Leone's CFO.com report of remarks made by Thomas Jones, vice chairman of the IASB:

"… in general, he [Jones] and other IASB members support fair value accounting for financial instruments, but 'don't believe in fair value for the factory or production machinery.' Jones observed that leaving aside the issue of mark-to-market accounting in an illiquid market, 'I think that fair value does capture reality.' The only thing historical cost captures regarding financial instruments is an 'accurate' but 'meaningless' number, he opined." [italics supplied]

Principles-based accounting didn't just lose, it was assassinated. "O, pardon me, thou bleeding piece of earth, that I am meek and gentle with these butchers!" (The Bard's Mark Antony to Caesar's corpse.)

It appears that Jones' position (and that of the other board members Marie Leone reported him to have spoken for) is that fair value measurements should be restricted to financial instruments that can be sold in a liquid market. If fair value has such limited application, and historic costs are meaningless, then perhaps neither one of these measurement attributes belongs in a principles-based system of financial reporting. Of course, as many of you may realize from reading previous posts, I believe I know which attribute does belong: replacement cost.

Mr. Jones evidently is of the opinion that fair values for "factory or production machinery" yield illusory measures of profitability – and I agree. To make the larger point as simply as possible, let's consider the implication of fair value on inventory. One does not simply make a profit by producing inventory; it has to be sold. That's because real wealth is "command" over goods and services, and no one can be commanded to buy what you produce. Perhaps somebody can be convinced to buy a car from GM (although it appears to be getting harder by the day), but having a car in inventory in no way represents command over anything – except for that car in inventory. (By the way, nobody can be commanded to buy your junk financial instruments from you either.)

The sense of the word "command" in economics is that every owner of an asset has their price; offer a high enough price, and at least in theory, anything that is legally salable is available for sale. That's why replacement cost of all of the assets at one's disposal is the economist's standard choice for measuring wealth.

Replacement cost as the attribute of an asset to measure also resolves both of the problems I have with Jones' positions. First, no number reported for an asset will be "meaningless." Replacement costs of financial instruments and producing assets is the money equivalent of already owning a resource instead of having to expend cash to acquire or produce it.

Second, the problem of illiquid markets for financial instruments goes away. A financial instrument is fundamentally a stream of risky cash flows. It is always possible to estimate how much it would cost to acquire the financial asset, and circumstances will dictate the most reliable method for making that estimate. The illiquid markets caveat is nothing more than code for "I can't find someone to buy my junk asset for the price I want to sell it."

I learned to write my name on my first day of elementary school. On day two, I learned that one plus one only makes two when we add two like things. Does anyone else see a problem with ceding accounting standards to a single group whose putative leadership sees no future for accounting except for one that violates the most basic rule of numbers and logic we all learned by the first grade?

1 Comment

  1. Reply Independent Accountant November 24, 2008

    I agree. These guys are too politicized.

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