Wednesday, February 11, 2009

A Few Comments on Previous Posts

Treasury Secretary Timothy Geithner had one job, as far as I was concerned in my post on the matter. The one good thing he could have announced yesterday regarding the O-ministration's plan to "save" the financial industry was that this was it. No more Bush-esque flying by the seat of our pants; we're picking a method and that's going to be it. More than taxes, regulation, or anything in between, the market hates ambiguity. FDR prolonged the Depression mainly through making investors scared to put their money in anything, for fear that Delano would change his mind about something next week.

So naturally, what does Geithner announce? He declares a broad-based plan the administration has devised, involving capital infusions, public-private partnering to buy toxic assets, and lots of other wastes of taxpayer money. The one thing missing from Geithner's announcement? CLARITY. Due to a lack of details, the market, especially financials, took a long, wet bath yesterday. What investors know, and what Obama may or may not know he is divulging, is that the guys with guns have no clue what they're doing, and are ready to try anything. Anything, that is, except nothing. Thank goodness Bush is out of office, right? Mmm...that's good change.

In other news, I am making a commitment now, as an incentive to generate comments, to respond to any thought-provoking comments or questions on this blog in post form. As such, I would like to respond to some comments Mitchell made on my Accounting Bitch #1 post. Mitchell writes:
Accrual based accounting works better in some instances. For example, if I sell an ad for a year on my blog, I get paid all at once, but the revenue is really earned over a 12 year period.

And as for accounting being a privately designed system... That would just make it be very inconsistent and manipulated. Every company could inflate their assets like Enron and there wouldn't be anything to stop them, then investors would get screwed.

First, regarding accrual based accounting: yes, in some instances accrual based accounting is more appropriate than cash-based. The idea inherent in Mitchell's example is called the "matching" principle, an accounting principle that states that revenues and expenses should be matched and recorded according to when they are earned. This is a valid concern, as cash results can make a company appear less profitable or more profitable than they really are. However, we must ask ourselves what the purpose of accounting is, and the main purpose is to represent the health of the firm. Mitchell's example could misleadingly make his website look secure, showing steady revenues over the course of the year, when in fact he is burning through cash and won't be able to replenish his reserves until the end of the year. A profitable firm can go bankrupt simply because of the timing of its cash flows. Something to consider.

My main beef with accrual-based accounting, however, is the haphazard, upside-down, rules-based way the government forces it on all public companies. Principles-based accounting versus rules-based accounting is another discussion topic altogether, but basically if the government is going to enforce any accounting regime, it necessarily must become rules-based. This is analogous to the difference between common law and statutory law. A written statute enforces rules, not principles. This pertains to Mitchell's second point, which is that companies would inflate their earnings. Again, there is a link to common law versus statutory law. Shareholders can always sue for fraud. The problem comes when it becomes impossible to prove fraud, because financial statements, misleading though they may be, are technically in accordance with federal statute. All sorts of private rating systems exist, from J.D Power and Associates to Underwriters Laboratories to the Good Housekeeping Seal of Approval. All of these systems rely on the reputation of the raters, and they guard those reputations very closely. Private accounting systems would be no different.

Side note: In an excellent book I've reference before, The Forgotten Man by Amity Shlaes, the author recounts a delightful story of how a female executive of Good Housekeeping, while a guest at the Roosevelts' home during the Depression, expressed great frustration with the President for undermining her business by strengthening the FDA. You just don't hear stories like that anymore.


  1. Mitchell:

    In response to your response to my response:

    It takes many years and much money to sue, especially over something as complicated as accounting fraud, and something like that would often never be known until the company went bankrupt or had major problems. Now if a company goes bankrupt, they can't pay back the investors they swindled, and the executives are basically protected as well. None of the investors in Enron got back what they put in.

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