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'Accounting for Value': Ignore this at your peril, part 2

Mark to market accounting | 'Accounting for Value': Ignore this at your peril, part 2 Anthony Harrington

In part 1 we looked at the implications of the distinction between price and value made by Stephen Penman, Professor of Accounting at the Columbia Business School. Part 2 concentrates on Penman’s argument that value accounting should not be contaminated with speculation. Here Penman is particularly exercised over the pointlessness of bothering one’s head over moment-by-moment revaluing of the business as the stock charts or asset prices yo-yo about - as is the case with mark-to-market accounting.

Accounting standards

This argument predisposes him to question the current combined efforts by the International Accounting Standards Board (IASB) and the US-based Financial Accounting Standards Board (FASB) to reshape international accounting standards. Penman, of course, is judging the accounting standard-setting effort from the standpoint of its likely usefulness to value investors:

“Where the two boards will end up is not clear at this point, but the project to date appears to be appealing to ambiguous accounting concepts like “recognition”, “measurement”, "balance-sheet focus” and “exit value” – ideas far from the investor’s mind – rather than focusing on the issues that investors face. “Fair value accounting” sounds good – like ice cream and apple pie – while “historical cost accounting” sounds, well, dated. But does “fair value accounting” actually help me to value my shares, or does it frustrate me? Could it be that historical cost accounting gives me a better way of accounting for value?”

Readers old enough to remember the “current cost accounting” debate that gripped the accountancy profession in the era of 10 to 15 percent inflation at the end of the 1970s and early 1980s will recognise that the profession always gets into a pickle when prices start to move around. There is nothing like rampant inflation to get accountants developing an acute sense of unease about the unrepresentative nature of past purchase price values in a company’s books.

These a once-a-quarter or once-a-year snapshots of where the company is in its affairs seem outdated and backward-looking when prices are sliding around. At bottom, this is an existential angst. Accountants start to worry about the relevance of what they are doing. It is so much more exciting to develop exotic ways of capturing “present value” to make everything much more relevant – “everything” here, of course, includes the work done by accountants. There is nothing surprising about this. Every profession inevitably talks up its own book. Even surgeons do it, hence their propensity to say things like: “You’re better off without it old fellow”.

Mark-to-market accounting

Penman sees this sort of mood shift coming a mile away. It conflicts flat out with Principles 6 and 7 in his list of ten “common sense” principles for value investors. Principle 6 states: “Understand what you know and don’t mix what you know with speculation”, while Principle 7 applies this edict to valuations:  “Anchor a valuation on what you know, rather than on speculation.” What is “fair value accounting” if it is not an attempt to lasso wild variations in pricing and haul them directly into the books?

The utility of mark-to-market accounting, Penman suggests, lies in its efficacy as an early warning system. Mark-to-market accounting “pulls the information on prices into the accounts immediately”, as he puts it, which enables the board to go “Oh my God!” and, hopefully, change course before the company falls off a cliff. But he points out that mark-to-market accounting is hopelessly dependent on efficient market theory. If there is a large giddy element in prices, that's not grounded in anything rational but is reflecting a surge of fear or greed in the market, mark-to-market accounting gets hopelessly contaminated. Instead of anchoring the company against the external storm the accountants end up leaping into the tornado and getting whirled away.

The trick, for the value investor, is to know when mark-to-market is useful, and when it is not. Here’s Penman’s view of the matter:

"If shareholder value moves one to one with the market [as with a bond in which a company has invested its excess cash], mark-to-market accounting indicates shareholder value (the bubble problem aside). Call it the one-to-one principle. However, when value comes not from exposure to market prices but from employing assets in a business (like coal for a steel manufacturer) which transforms these assets into products for sale to customers, market prices do not indicate value”."

Penman cites the example of someone trying to value the coal held on a steel foundry’s books by reference to market price. That price bears little relationship to the value of the coal to the company which requires it to power the furnace. “A coal speculator wins or loses with the movement of market prices, one to one, and those market prices inform about success. But a steel producer holds coal to add value in steel production, and value is added by success in selling steel, rather than one-to-one with the price of coal,” he notes.

The dangers of the 'one-to-one' principle

If you combine the “one-to-one” principle (which Penman warns acts as a huge constraint on the usefulness of mark-to-market or “fair value” accounting) together with what I have called the giddy element in pricing, then, as he puts it: “fair value accounting must come with a large, bold-type product warning label. The fundamentalist has the label ready: “When calculating value to challenge price, beware of putting price in the calculation.”

The dangers of conflating price with value, of course, was the point of part 1, so we end where we began. Part 3 takes up Penman’s evaluation of modern financial engineering.

Further reading on mark-to-market accounting and valuing shares:

Tags: fair-value accounting , fundamental value , mark-to-market accounting , price versus value , Steven Penman , value accounting
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