22 October 2011

The Paradox of Accounting Value

The Adam Smith Institute has a post praising mark-to-market accounting, named thusly because assets are marked at their market value during the closing period (usually monthly or quarterly).  While I think that mark-to-market accounting is a good idea, it’s helpful to take a step back and understand consider why accountants might be reluctant to accept this.

Accountants, in a sense, are historians, insofar as their job is to provide an accurate and objective record of the financial transactions of a firm or an individual that occur in a specific time frame.  As such, accountants are very concerned with minimizing subjectivity when it comes to reporting the financial state of a firm.  Of course, some subjectivity is inherent in this endeavor (e.g. choosing the method by which one depreciates capital assets).  Still, subjectivity is to be minimized as much as possible.

Therefore, it should not be surprising that accountants prefer a system wherein asset valuation is determined by the last recorded market transaction regarding the aforementioned asset, otherwise known as a transaction or sale.  When a firm sells or buys an asset, it provides an objective measure of value, otherwise known as a price.  And since the accountant functions as an historian, in a sense, the accountant can say that a given asset was valued at x at a given point in time.  Now, it may be the case that said asset may no longer be valued as such now, but it was the case the aforementioned asset was valued at x at a given point in time, as evidenced by the exchange.

Ironically, this focus on objectivity presents a paradox at this point in time.  Many assets, particularly houses owned by banks due to foreclosure, are overvalued, but no one knows by how much said assets are overvalued.  The last known price almost certainly places too high a value on said assets.  The paradox is thus:  the current methods of valuation require a tradeoff between accuracy and objectivity.

The mark-to-market method of valuation would provide a more accurate estimate of asset value than last known price in many cases, but this is nothing more than an educated guess.  And educated guesses are not easily defended, especially when later proven wrong.  However, any attempt at objective valuation is likely to be wildly wrong, especially now that the housing bubble has popped.  So, accountants are stuck in the unenviable position of choosing between objectivity and accuracy.

No comments:

Post a Comment