An article in the London daily Financial Times on 2 August raises profound questions about balance sheets and profit and loss statements used by investors to value the financial assets they buy.
“In the UK in the past three decades, standards setters have progressively dismantled the system of historic cost accounting, replacing it with one based on the idea that the primary purpose of accounts is to present information that is “useful to users”,” the FT says.
“The process allows managers to pull forward anticipated profits and unrealised gains, and write them up as today’s surpluses.”
The FT says this is behind recent accounting scandals including at Tesco, Quindell, Carillion and GE.
An investigation has started into the effectiveness of the Financial Reporting Council, the UK’s auditing regulator.
“But this may be looking at the symptoms rather than the cause of the problem,” the FT says. “That may lie in the accounting standards themselves.”
The FT says that auditors are now attempting to estimate a company’s fair value. This inevitably is an estimate; a probability-based projection rather than a fact based on empirical data.
The FT focusses on the concept of goodwill, an estimate of the price a company pays for an asset and its assessed net value.
Until 2000, auditors counted it as a cost of a transaction that had to be amortised (or reduced in value over time). Since then, it’s been counted as a permanent part of the balance sheet. It’s only reduced if there’s evidence that discounted cash flows projected for the asset have sufficiently fallen to warrant revaluation.
Such measures are rarely taken. The total goodwill on the balance sheets of S&P500 companies was $2.9trn in 2016 compared with £1.8trn in 2007.
Carillion, the UK service provider, had total goodwill of £1.5bn on its balance sheet when it collapsed in January 2018.
The FT says that these trends are in part due to concentration in the auditing industry. PwC, Deloitte, KPMG and EY now dominate the sector. In 2017, they had combined revenue of $134bn and employed almost 1m people.
They are also increasingly the target of litigation from investors about their valuation of corporate assets.
That is encouraging the Big Four auditors to press for further relaxation in standards for an industry that is now seen as being too big to fail.
Economics2030 can see no evidence that the audit industry or the companies they are supposed to regulate are prepared to take steps to deal with an issue that must inevitably lead to corporate collapse.
This should mean more government action. But there’s little evidence of that either.
And even where it’s happening, the state is targeting the wrong thing.
Government’s focus on regulation, but that’s pointless if the assets that are being regulated can’t be valued because they are intangible.
The only approach that will work is to force companies to reduce the proportion of intangible (and consequently unquantifiable) assets on their balance sheets.
Rules requiring companies to have at least half their assets in a physical form would drastically reduce valuation problems and the risks now silently accumulating with the active assent of both auditors and corporate managers in the balance sheets of a growing proportion of companies everywhere.