The true and fair view is subjective, and no accounting principles, however extensive, can cover all conceivable situations.
I never imagined that mark-to-market accounting would be the theme of a sell-out musical comedy. Or that actors would audition for parts as special purpose vehicles on the West End stage. But if you beg, borrow or steal a ticket for Enron at the Noël Coward theatre in London’s West End, you will discover that the financial crisis has made a topic that was once a guaranteed conversation-stopper the talk of the town.
For centuries the accounting principle was that gain should be recognised only when realised. Like most economists, I favoured the shift to mark-to-market principles. The older approach is objective and seems conservative, but the price of its objectivity is to mislead. Often it is fortuitous which gains are realised and which are not. If it is not fortuitous – if institutions can decide which gains to realise and which not – then a principle that appears conservative may in practice prove just the opposite. Any alternative to universal mark-to-marketing accounting gives carte blanche to creative finance directors.
And yet I realised that I did not apply mark-to-market principles in my own life. Like most homeowners, I would pass the windows of the local estate agents and take a surreptitious look at the prices of houses that resembled my own. This information was of no operational value to me since I did not plan to sell. There probably was a price at which I would have considered selling. But, like most homeowners, I like the house I live in, have invested love and money in it, and would feel cheated if forced to sell it for the market price. Since I would, in any event, plan to live in a house of similar quality, I have an implicit liability, which more or less corresponds to the value of my house, whatever that may be. Still, the market price is of real interest to my creditors, which is why, when I remortgaged the house – not recently – I willingly paid for a valuation that was of no real interest to me.
I have, however, felt more convinced of the virtues of mark-to-market accounting since hearing how banks applied identical arguments to toxic assets on their balance sheets. They suggested that the contribution to capital adequacy of toxic assets should reflect their cost, or the banks’ own assessment of their value, rather than the judgment of a sceptical marketplace.
Presumably, like a homeowner, they liked the assets they held, they would have felt cheated if forced to sell for the market price and, if deprived of these tasty investments, would have filled their books with others of similar quality. Whatever their beliefs or intentions, however, the obvious difference is that capital adequacy is not calculated for a bank’s operational purposes, but for the protection of a bank’s creditors.
At other times, market values are flattering. Enron, the musical, begins with the US energy trader’s (now jailed) president Jeff Skilling holding a champagne party with his colleagues. Not to celebrate a deal, or a promotion, or to toast Enron’s ever rising share price: but to recognise the arrival of a letter from the Securities and Exchange Commission approving the wider use of mark-to-market accounting in Enron’s business.
The attraction of mark-to-market accounting for Mr Skilling was that it allowed his good ideas to be reported in accounting profits straightaway: there was no need to wait for these good ideas to come to fruition. But the proponents of good ideas are often prone to an optimistic assessment of how good the idea is. And even the most robust of auditors, which in the modern world is not very robust, is ill-placed to make an assessment.
We are dealing with questions to which there are no right or wrong answers. The true and fair view is subjective, and no accounting principles, however extensive, can cover all conceivable situations. The appropriate measure always depends on the purpose for which accounts are properly to be used. The only certainty, however, is that these proper purposes do not include flattering the egos of corporate executives or enabling banks to take deposits on false pretences.