Sunday, October 11, 2009

Accounting & the Economy

Discarded Image from University of New Hampshire student sever.

And now we come to the boring subject of academic accounting. Mostly, it affects Bankers who are in too much of a hurry to inspect a company's books and Investors with more money then sense - or too little of both. Unfortunately, these people affect the economy too. Thus, accounting standards that unfairly favor one industry over another can have a genuine effect on the economy.

In addition, taxable income (as reported in income statement) has an uncanny ability to affect taxes paid. And what the accounting rules say, you do - penalties range from being shamed in front of investors, to jail time for Chief Executives.

As we continue our magical mystery tour of the world of accounting, one general rule of cause and effect for readers: When taxable income is made higher, those that need investment capital benefit as both banks and stock investors see a higher income. But when taxable income is lower, less taxes need be paid on income. The greater investment generally helps smaller businesses, while the lower taxes helps those already established to want to invest and expand to begin with.

Software Development

A good first example of the way accounting affects us all is research and development. R&D, though really an investment, cannot be "capitalized," or apply to the asset price, of a product as the products very existence is uncertain. Instead, it must be applied to Expenses, lowering a companys' quarterly profit. But there's exception.

You see, software developers are allowed to apply R&D costs to asset price after "technological feasibility" (loosely defined term that can be set arbitrarily so long as you don't spook investors with how arbitrary you set it) has been reached. This means that software developers show larger profits then anybody else who does R&D, tricking investors not "in the know" in to thinking they are more profitable then they are. If we applied the same logic to the auto industry, they could start recording development cost to asset price as soon as they'd decided to make the vehicle concept a production car. Lower profits mean less investment among less educated or industrious creditors and investors, giving the software industry an artificial advantage over all other firms that must create their own intellectual, and especially engineering or science, property.

Lower Exports

The US Constitution says "congress shall not enact an export tariff," but in effect America has an export tariff in the form of inventory standards. See, American companies can apply LIFO standards, or Last-In, First-Out, standards to there inventory, allowing them to understate how much profit they gained from the products they sold (inflation), and thus pay lower taxes, but when such a company sells goods to foreign countries, they must use either First-In, First-Out or Average-cost standards, which decrease the original value of the inventory (via inflation), and thus raise the taxable income of these companies. This discrepency exists because in America you must use the GAAP standards, which allow LIFO inventorying to understate taxable income, while in most other countries (over 100 total) you must use IFRS standards, which do not. This leads to an effective export tariff in the form of higher income taxes, discouraging American businesses from engaging in export trade.

Now, for some companies that doesn't actually affect them, and it doesn't affect them because they need so much investment capital to develop their products and expand production that they will use First In, First Out standards to increase income so that investors see them as more profitable. As there is less export of the other, older industries that would rather have the lower taxes, the cost of exporting to other countries (shipping, currency exchange, et cetera) declines, giving these companies an artificial boost.

Huge Conglomerates

Sometimes people complain about corporations being too large. Here's a secret. Our accounting standards make them too large. See, when a company buys another for more then Assets - Debts, they get an intangible asset, an intangible asset that the original company didn't have, called "Goodwill." "Goodwill" can only be gained by buying a company out for more then Assets - Debts. We increase the value of companies, to investors and creditors, especially lazy and ignorant ones, when they get sold to other companies. Over-sized conglomerates get an advantage in acquiring capital over the original businesses that made them up, and not one that comes from any intrinsic value of the conglomerate.


The Sarbanes-Oxley act of 2002 was enacted to prevent the kind of corporate abuses and widespread bad behavior that defined the ENRON and WorldCom scandals. Most of the reforms of Sarbanes-Oxley were pretty common-sensical, you know, don't let the person who handles the money record it, assess your risks always, monitor your internal controls, and let the board of directors hire the auditors, stuff like that, but there are two particular aspects of internal controls that can cause distortions:

"Control Environment" is described as a general subjective vibe, without any objective standards. As such it may well mean, as it is accountants judging this general vibe, excessive rules making, "ethical behavior" such as not swearing or drinking whiskey, and lots of "team" values. This helps industries that benefit from such attitudes, but my guess is your average steel or logging mill with heavy drinking joe six-pack and whiskey-drunk axe-throwing contests, those within the business aren't clean shaven enough, and they end up hiring outside of the industry for management so the accountant will sign off on their internal controls.

In addtion, "Information and Communication" requires constant reporting of everything, new sales and the works, which for companies that sell small numbers of high-valued goods (like diamonds) adds a lot of additional labor, all so investors will trust them.

Discouraging the selling of stock

These new standards only apply to publicly-traded companies, which gives private-companies (single owner, family, and partnership) an artificial edge. See, companies that must abide by Sarbanes-Oxley take a lot more work to prepare their financial statements, leading to the need to hire more accountants and more billable hours. This gives a further edge to private companies with their simpler, more objective financial statements.

Conclusion and Post-Summary

These are just a few elementary examples about how small flaws in the consistency of accounting can lead to distortion and misappropriation of resources in the economy. The most important job of an accountant is to represent all relevant information in an objective manner, but the very standards that Accountants must use are inherently flawed. When the standards are flawed, the information is biased, and the biased information distorts taxable income (and thus taxes paid on income) and stock prices (and thus investment available.) This gives some companies a leg up and some a shove down. It also distorts trade (due to the 2 separate standards for out of country and in country) and, through the subjectivity and labor costs of Sarbanes-Oxley, discourages companies from being publicly traded. Software companies can develop intellectual property themselves, and record it as investment, while all other companies must count it as loss. In short, the economy is bullied by accountants.

Sources (1, Print)
Financial Accounting, Spiceland, Thomas, Herrmann, First Edition, McGraw-Hill

If you viewed this prior to October 12th at 5:43 PM, no sources had yet been added. My apologies to all who did for leaving out such vital information.

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