Financial Crisis: The Failure of Accounting Reform by Jesus Huerta de Soto

[Stephane Budge]

The years of "irrational exuberance" that have characterized the
current economic cycle have culminated in a profound crisis in both
the banking system and financial markets, a crisis that threatens to
trigger an acute, global economic recession. A central feature of the
recent period of artificial expansion was a gradual corruption, on the
American continent as well as in Europe, of the traditional principles
of accounting as practiced globally for centuries.

To be specific, acceptance of the International Accounting Standards
(IAS) and their incorporation into law in different countries (in
Spain via the new General Accounting Plan, in effect as of January 1,
2008) have meant the abandonment of the traditional principle of
prudence and its replacement by the principle of fair value in the
assessment of the value of balance-sheet assets, particularly
financial assets.

In this abandonment of the traditional principle of prudence, a highly
influential role has been played by stock brokers, analysts,
investment banks (fortunately now on their way to extinction), and in
general all parties interested in "inflating" book values in order to
bring them closer to supposedly more "objective" stock-market values,
which in the past rose continually in an economic process of financial
euphoria.

In fact, during the years of the "speculative bubble," this process
was characterized by a feedback loop: rising stock-market values were
immediately entered into the books, and then such accounting entries
were sought as justification for further artificial increases in the
prices of assets listed on the stock market.

In this wild race to abandon traditional accounting principles and
replace them with others more "in line with the times," it became
common to evaluate companies based on unorthodox suppositions and
purely subjective criteria that in the new standards replace the only
truly objective criterion (that of historical cost). Now, the collapse
of financial markets and economic agents' widespread loss of faith in
banks and their accounting practices have revealed the serious error
involved in yielding to the IAS and their abandonment of traditional
accounting principles based on prudence, the error of indulging in the
vices of "creative," fair-value accounting.

It is in this context that we must view the recent measures taken in
the United States and the European Union to "soften" the impact of
fair-value accounting for financial institutions. This is a step in
the right direction, but it falls short and is taken for the wrong
reasons.

Indeed, those in charge at financial institutions are attempting to
"shut the barn door when the horse is bolting"; that is, when the
dramatic fall in the value of "toxic" or "illiquid" assets has
endangered the solvency of their institutions. However, these people
were delighted with the new IAS during the preceding years of
"irrational exuberance," in which increasing and excessive values in
the stock and financial markets graced their balance sheets with
staggering figures corresponding to their own profits and net worth,
figures that in turn encouraged them to run risks with practically no
thought of danger.

Hence, we see that the new standards act in a procyclic manner by
heightening volatility and erroneously biasing business management: in
times of prosperity, they create a false "wealth effect" that prompts
people to take disproportionate risks; when, from one day to the next,
the errors committed come to light, the loss in the value of assets
immediately decapitalizes companies, which are obliged to sell assets
and attempt to recapitalize at the worst moment, i.e., when assets are
worth the least and financial markets dry up.

Clearly, accounting principles that, like those of the IAS, have
proven so disturbing must be abandoned as soon as possible, and all of
the accounting reforms recently enacted (specifically the Spanish one,
which came into effect January 1) must be reversed. This is so not
only because these reforms mean a dead end in a period of financial
crisis and recession, but especially because it is vital that, in
periods of prosperity, we stick to the principle of prudence in
valuation — a principle that has shaped all accounting systems from
the time of Luca Pacioli at the beginning of the 15th century to the
adoption of the false idol of the IAS.

In short, the greatest error of the accounting reform recently
introduced worldwide is that it scraps centuries of accounting
experience and business management when it replaces the prudence
principle, as the highest ranking among all traditional accounting
principles, with the "fair-value" principle, which is simply the
introduction of the volatile market value for an entire set of assets,
particularly financial assets.

This Copernican turn is extremely harmful and threatens the very
foundations of the market economy for several reasons.

First, to violate the traditional principle of prudence and require
that accounting entries reflect market values is to provoke, depending
upon the conditions of the economic cycle, an inflation of book values
with surpluses that have not materialized and which, in many cases,
may never materialize. The artificial "wealth effect" this can
produce, especially during the boom phase of each economic cycle,
leads to the allocation of paper (or merely temporary) profits, the
acceptance of disproportionate risks, and, in short, the commission of
systematic entrepreneurial errors and the consumption of the nation's
capital to the detriment of its healthy productive structure and its
capacity for long-term growth.

Second, we must emphasize that the purpose of accounting is not to
reflect supposed "real" values (which in any case are subjective and
which are determined and vary daily in the corresponding markets)
under the pretext of attaining a (poorly understood) "accounting
transparency." Instead, the purpose of accounting is to permit the
prudent management of each company and to prevent capital consumption,
by applying strict standards of accounting conservatism (based on the
prudence principle and the recording of either historical cost or
market value, whichever is less), standards that ensure at all times
that distributable profits come from a safe surplus that can be
distributed without in any way endangering the future viability and
capitalization of the company.

Third, we must bear in mind that market value is not an objective
value: in the market, there are no equilibrium prices that a third
party can objectively determine. Quite the opposite is true; market
values arise from subjective assessments and fluctuate sharply, and
hence their use in accounting eliminates much of the clarity,
certainty, and information balance sheets contained in the past.
Today, balance sheets have become largely unintelligible and useless
to economic agents.

Furthermore, the volatility inherent in market values, particularly
over the economic cycle, robs accounting based on the "new principles"
of much of its potential as a guide for action for company managers
and leads them to systematically commit major errors in management.
Moreover, if this state of affairs is serious for a financial
institution, it is much more so for any of the small and medium-sized
enterprises, which make up 90 percent of the industrial base.


Fourth, we must remember that the abolished accounting standards
already stipulated that in the additional notes of the annual report,
stockholders be informed as of a certain date of the market value of
the largest assets; but this in no way affected the stability nor the
traditional principles of prudence demanded by any accounting
assessment of the different entries in the balance sheet. Furthermore,
the accounting standards abolished were prudent and anticyclic, and
they allowed for provisions to cover all sorts of contingencies,
provisions sadly missing now.
Conclusion

Just as "war is too important to be left to the generals," accounting
is too vital for the economy and everyone's finances to have been left
to the experts, whether they be visionary professors, auditors eager
to strengthen their position, analysts, (ex-)investment bankers, or
any of the manifold international committees. All have been as
arrogant in the defense of their false science as they have been
ignorant of their role as mere sorcerer's apprentices playing with a
fire that has been on the verge of provoking the most severe financial
crisis to ravage the world since 1929.