John Kay - The market is not the best place to set a fair price for assets

The market is not the best place to set a fair price for assets

Listed companies in Europe are required to prepare accounts in accordance with International Financial Reporting Standards. The directors of these businesses have a statutory obligation to ensure that the accounts present a true and fair view of the company’s affairs.

Are these duties consistent with each other? Two weeks ago, a group of institutional investors wrote to the Financial Times arguing that they were not, with a supporting counsel’s opinion. The problem caused so much concern to the Parliamentary Commission on Banking Standards that it proposed that banks should have two separate sets of accounts. Banks are at the centre of the controversy, although the issue is a more general one.

The main source of difficulty comes from the way in which accounting standards – both IFRS and the US Generally Accepted Accounting Principles – have moved from “prudence” towards “neutrality” and from “historic cost” to “fair value”. That emphasis implies insistence on marking trading assets to market prices.

Concern is often expressed about the difficulty of applying mark-to-market principles when there is no active market. Actually, the larger problem arises when there is an active market. The greater the volume of trading, the greater the extent to which prices are determined not by informed assessment of fundamental value but by speculation.

There is a deeper economic issue here. A contradiction lies at the heart of the efficient market hypothesis: if market prices did incorporate all available information about the value of an asset, no one would have an incentive to obtain that information in the first place. The perverse implication of asserting that the market price of one’s assets measures their fair value is that the people best placed to supply information about fair value – the owners – abandon the attempt to make such an assessment in favour of the judgment of traders. And this is not an academic quibble: what happened at Enron, and in the banks, was that trading assets were marked to values that had been established not by people who knew about the contracts or the loans, but by the biased and ill-informed assessments of the traders.

A principal purpose of corporate accounts is to provide data on business activities that might inform the judgment of the market. To use the judgment of the market as a basis for corporate accounts is to get things the wrong way round. Pursuing the logic of mark-to-market accounting to its extreme would allow the lazy chief financial officer to compile the annual accounts by looking at the company’s share price, which determines what it is worth; and measuring the total investor return over the year, which would represent the profit or loss.

To express reservations about the primacy of mark-to-market principles is not to say that assets are best valued at historic cost. Market prices may often provide insights of relevance to managers and investors. But one can acknowledge that utility without adopting an ideological commitment to the infallible, or at least irrefutable, wisdom of the market. In the past decade, the efficient market hypothesis has been mugged by reality.

It is understandable that, with experience of crooked executives and faced with potentially onerous legal liabilities, accountants should have sought to hide behind increasingly complex and supposedly objective rules. The desire for a set of general principles that can be applied to all businesses whatever the nature or location of their activities is understandable. But this search is misconceived. Comparability and consistency are of little value if won at the expense of relevance. The preparation of accounts that reflect a true and fair view of corporate affairs is necessarily both a pragmatic and an eclectic activity.

Accounts have many users and many purposes, and these vary with the nature of the business and the environment in which it operates. The nature and content of appropriate financial information should be a matter for negotiation between the companies that prepare accounts and the parties who use them. It would be a mistake to abandon requirements for prudence, truth and fairness in corporate reporting. And prudence, truth and fairness are the product of judgment and personal responsibility, not the observance of particular procedures.

 

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