Thursday, 25 June 2015

Unbalanced sheet

To understand a subject I need to hang around with it for a long time.  Take balance sheets.  The context: regulatory bodies force companies to expose themselves four times a year, with an annual big exposure.  they impose a partial form and partial meaning on the semantics which go into this exposure.  There are other so-called extraordinary (read: irregular) requirements on a firm's reporting obligation.  But the most detail you will get, and in a time series as regular and as stable as the regulatory framework which underpins this obligation, happens with quarterly reporting.

A company, on 4 equally spaced out dates during the 260 day working year (on about 1.5% of the days) will need to go to the expense of producing the quarterly report.

First up is the balance sheet.  This is an atemporal list of assets and liabilities, with the remainder of assets minus liabilities being called the equity of the company.  The owners of the company (the shareholders, the slave owners) own whatever's left if a sale of all assets happened and all the bills (liabilities) are paid.  Unfortunately, however, the assets are recorded on a balance sheet with value in play at purchase.  That is to say, the assets are marked on a historical cost basis.  Not ideal.  Kind of like reading the ancient price sticker on an item.

 One way to think of accounting per se is a land where sophisticated models are banished.  It is in many ways a discipline which operates on pure reads from documented (and as uncontroversial as possible, provable, unquestioned) numbers.  So in many ways it is a bit like compliance (and indeed it is driven by the same kind of regulatory exposure which goes on in a typical compliance department).  

Take the case of assets.  In general, it is a non-trivial exercise to judge the value of an asset at any moment in time.  Accounting is the discipline which has found a way to side-step this rather difficult question but answers it always with the asset's purchase price.  Likewise the liability is reflected on an at-the-time notional basis.  Remaining interest payments are taken into consideration but on a non discounting basis.  This of how simple a model of the movements of asset prices it is.  The asset has an observed purchase price.  It remains at this value with depreciation applied over the reasonable life of the asset.  The asset itself may or may not generate cash flow too.  Whilst this rather simplistic 'price tag and wither' model is implicitly attached to the asset, real life assets can be driven by a complex market-inspired array of inputs.

Take a company which owns real estate property.  Over the years, the price of a property will rise and fall with market conditions.  But the financial balance sheet statement will only show the purchase price with income and amortisation adjustments.  The income generated by the asset will itself either have gone into funding the asset base or reducing the borrowing of the firm.  Continuing the housing analogy, the market value of the asset is estimated in a role akin to the surveyor.  Accountants by analogy would simply consult the most recent value in recorded in the land registry record and dispense with the need for a surveyor.  Another way to think of the accounting approach to valuing assets is to realise that the approach makes calculating any capital gain or loss easy.

Small business reporting of quarterly statements (or its precursor) can be construed as being all about laying out your taxable obligation.  Indeed, the small business owner gives his accountant the set of transaction dates partly to make sure the firm's tax obligations are,  Historical cost accounting is also as a result in line with the cash flow statements.