Book Review: Early Warning and Quick Response

Early Warning and Quick Response

If you are not into accounting, you can skip this review.  Before you skip it, though, ask yourself a question.  Do you rely on financial statements?

Most of us do whether we admit it or not, but accounting rules for most of us are like plumbing.  We need to use bathrooms, and sinks in our kitchens, but that doesn’t mean we would know how to set up the plumbing in a kitchen or a bathroom.

In the same way, most users of financial statements don’t have the vaguest idea of all the assumptions underlying financial statements.  Modern financial reporting today is a hodgepodge of rules straddling two eras: the Renaissance/Reformation era, and the modern era.

In the R/R era, accruals were almost always short, liquidating within the next few accounting periods.  Few items on the balance sheet were traded, or would have prices that would adjust materially before they would be used or sold.

In the modern era, accruals are frequently longer and less certain.  Many items on the balance sheet are tradable, and prices often move materially before the items are used or sold.  What is more, there are often hybrid financing instruments that make the estimation of equity versus liabilities difficult.

David Mosso grasps the nettle, and says that modern accounting must move entirely to a fair value basis.  Net worth is the difference between the fair value of assets and liabilities.  Net Income is the change net worth.  No more obfuscation.  No more AOCI.  No more goodwill.  The values of assets and liabilities derive from the future cash flows they will generate.  Even claims against equity must be done on a fair value basis, where hybrid instruments get decomposed into an equity claim and a debt claim, and the split gets re-evaluated each period as market prices change.

All measurable assets and liabilities must go on the balance sheet, and all nonmeasurable assets and liabilities must be disclosed.  Beyond that, financials should be segmented by major lines of business or marketing channel or geography in order to give users a greater sense of what is going on.

Measuring wealth, and the increase in wealth is the main metric.  This would apply to all entities — nonprofits, governments, etc.  No longer could we do a monstrosity like “cash for clunkers,” where we destroy autos and do not record the loss in GDP, but we add to GDP the sales of autos generated.  I can think of many transactions at a usually scrupulous company that I worked at, where the new and unscrupulous CEO and CFO found ways to convert capital losses into operating income, giving ROE a big boost –> R up, E down, and letting management take home large bonuses as a result.  That said, the only real loser was another mutual life insurer that bought the company after insufficient due diligence.

The book has much more to it than this.  It delves into how to set accounting standards better, and spends time more closely defining fair value with respect to assets, liabilities, and equity claims.

The changes would be sweeping, and widely opposed by much of industry, as well as utility and financial businesses.  The government would never let such standards be applied to them; honesty is alien to them.

I have a hybrid proposal, which I would view as transitional, that I proposed to a commissioner of IASB at a Society of Actuaries meeting five years ago.

I said, “I am a user of financial statements, and we need an upgrade in the quality of data that we receive from accounting.  What we need are five main financial statements.  Book value balance sheet and income statements, supplemented by Fair value balance sheet and income statements, with a cash flow statement to round them out.  This would give us the flexibility to chose our own accounting basis.”

The lady had a horrified look on her face, and said “But that would be so costly to do.”

I replied, “Most of these estimates are being done already by companies.  This would formalize it.  Besides, to my friends here (turning around to the back of the room, catching grins, and then looking at her) this is the actuarial full employment act, because the work of estimating long-dated accruals is something that needs professionals like actuaries.”

No comment, and they went to the next question.

Quibbles

The devil is in the details here.  Anyone who has read me closely for a long time knows that I am of two minds when it comes to Fair Market Value accounting.  My experience is that managements, when given freedom to estimate the value of assets, tend to estimate them too high, and liabilities too low.  Historical cost accounting may be wrong, but it is relatively determinate.  There is comparability when managements don’t have a lot of latitude to change values.  After that, it is the job of investors to figure out how good the accruals are.

But on the plus side, fair value accounting does give the snapshot view of net worth, which managements resist in a crisis.  They want book value accounting that presumes the likelihood of reversion to all claims being paid.  Sorry that doesn’t always happen, and accounting should probably reflect it, even if it ruins comparability across firms.

Who would benefit from this book

Users of financial statements that want to think a little more broadly about accounting should buy this book.  Note that the sticker price of this book is stiff, at roughly $1 per page.  Accounting mavens, whether they like the ideas should buy the book so that they can understand the issues involved.  Even if they never become the standards, the ideas are the exemplar for fair value, and represent the opposition view in accounting.

If you want to, you can buy it here: Early Warning and Quick Response: Accounting in the 21st Century (Studies in the Development of Accounting Thought).

Full disclosure: The publisher sent two copies, after I asked to receive a review copy.

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PS — The book looks mush nicer than the cover that I scanned, with the abuse that I gave the book.