Companies must reclaim prudent accounting principles

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Prudent accounting balances the forces that drive a business to be efficient and resilient by helping a business stay light on assets and forcing it to roll back failed projects as their losses become apparent, even in otherwise good times. . Such a business is therefore less likely to throw good money after bad money, reducing waste in the business and in the economy. And, in bad weather, the business is less inclined to incur unwanted costs, a huge relief for everyone, including the taxpayer. Likewise, when a prudent company goes into debt, it does so despite the downward trend in its accounts, so the debt is safer as long as it rests on a more conservative cushion. This makes the company and its creditor less likely to go bankrupt in a crisis. And finally, by being cautious in good times, the company recognized its losses earlier and dampened the scale of its dividend and bonus payouts. This means that there is more buffer in the capital retained to get through a crisis.

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Beyond its human toll, the Covid-19 has imposed a heavy economic toll on us. In just two weeks in mid-March 2020, entire industries and sectors were brutally brought to a halt. In the UK, for example, car manufacturing has fallen from over 70,000 cars in April 2019 to just 197 cars in April 2020; for more contrast, the UK manufactured over 120,000 units in February 2020.

Further reading

To survive a crisis like this, a business must be both efficient and resilient. Prudent accounting – the common-sense accounting concept that there should be a higher threshold for recognizing anticipated gains versus accounting for anticipated losses – had helped businesses for generations to balance these two pull factors. In turn, companies were better prepared for an unforeseen blow. Then, around the turn of the 21st century, accounting lawmakers abolished caution. We are living the consequence today: the economy is full of shitty balance sheets that require gargantuan bailouts in the event of a crisis.

Now, concerned about the anemia of bank lending to industrial companies, regulators have further reduced their caution. The Fed recently relaxed a key accounting restriction which encouraged more responsible lending and guaranteed banks strong protection against crisis-induced losses. In the UK, the central bank is so alarmed by the weakness of corporate lending that it is urging financial institutions not to recognize large charges on potentially bitter loans. These practices are the opposite of prudence.

A financial crisis like ours was not unimaginable. It was only a little over a decade since the world last suffered a sudden shock to global industrial solvency, and the idea that such a shock could come from disease has been made very real. by the narrowly averted Ebola and Zika epidemics of 2014 and 2016 So the real question is how to avoid ending up here in the face of the next big economic shock? One answer is to bring “prudence” back to business accounting.

How prudence balances resilience and efficiency

Resilience is the ability to resist and recover from negative shocks. Resilience is soft – the ability to absorb failure and keep going. You are not resilient if you continued to keep this loss-making division instead of closing it. You are also not resilient if you have underutilized debt to grow your business, as that likely means you haven’t diversified to a level where you can now afford a few failures.

Efficiency simply means more production and less waste for a given amount of input. Effective organizations are light on assets and more leveraged compared to their peers – features that seemingly make them less resilient. They seem to have fewer reserves to draw on when the rains fail. But being a lightweight asset really means you carry less excess baggage when you need to get around quickly; it doesn’t mean you got rid of the essential baggage. Companies, like those who want to diet, often get it wrong in their quest to lose weight. Likewise, being more in debt than your peers means you can do more with less capital, which can be extremely beneficial when capital is scarce, such as during a crisis. The key is to only take on the leverage you need to operate at an effective scale and scope, and not to take on the leverage to pay dividends or bonuses, like many banks do. did before the last financial crisis.

Prudent accounting balances the forces that drive a business to be efficient and resilient by helping a business stay light on assets and forcing it to roll back failed projects as their losses become apparent, even in otherwise good times. . Such a business is therefore less likely to throw good money after bad money, reducing waste in the business and in the economy. And, in bad weather, the business is less inclined to incur unwanted costs, a huge relief for everyone, including the taxpayer.

Likewise, when a cautious company goes into debt, it does so despite the downward trend in its accounts – so the debt is safer because it rests on a more conservative cushion. This makes the company and its creditor less likely to go bankrupt in a crisis.

And finally, by being cautious in good times, the company recognized its losses earlier and dampened the scale of its dividend and bonus payouts. This means that there is more buffer in the capital retained to get through a crisis.

Return to Caution

Prudence is both a principle of regulation and a managerial state of mind. Reducing prudence in accounting therefore requires two levels of action. First, the United States Securities & Exchange Commission (and its equivalents around the world) should require that any new accounting standard – and indeed any accounting standard issued since about 2000 – pass the test of prudence. In other words, these standards should require objective evidence before companies can register gains (or avoid losses) based on expected future profits.

Second, boards and auditors should be more skeptical when approving CEO and CFO judgments on highly discretionary items such as capitalization of intangibles and avoidance of write-off. goodwill. Anticipating such a setback, senior management will then impose their own higher standards in making these decisions, resulting in better quality balance sheets.

Prudence in accounting practice has been around since at least the 1400s, and by the end of the 19th century and the advent of modern capitalism, it was already a well-developed and widely regarded principle. We foolishly ditched this story just recently, but two major financial crises and billions in bailouts later, we have to get it back.

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