11 November 2010

Financial accounting: In communicating reality, we construct reality

Obama's debate about financial regulation in the US at the time (about 7 months ago now) was about lending and operating regulation.  It was not about accounting standards.  At least not directly. Financial Accounting is merely reporting what the business has actually done.  But the way you report things will have an impact on people’s decisions. 

So, take for example the use of security cameras in a bar or at a train station.  The cameras are not policemen or security guards, they don’t physically STOP an assault occurring, they just record the assault occurring.  But that said, most people are aware of the cameras and are concerned about future impacts (like going to court and eventually jail).  So by actually observing, recording and reporting the act, this will impact upon people’s behaviour.

So if we decide we are going to mark all our assets at fair value and wash the changes through the profit and loss report, this will change the agent’s (manager’s) decisions as to what sort of risks they take, which project they invest in, and what sort of legal vehicles they house the investments in.  By reporting the “reality” we are changing the reality.  People become accountable to what is reported.  But you have to remember that the accounting standards play a huge role in the construction of that “reality” we are reporting. 

For example, when we moved from old Aussi GAAP to IASB standards, Australian companies were no longer able to recognize internally generated goodwill, mastheads, customer lists, and other non-purchased brand names.  This means that companies like Fairfax (The Age newspaper) had to write off their brand name out of assets.  Nothing changed in the operating reality, but the company’s balance sheet shrunk massively over night.  Because it LOOKED like a smaller company, many investors lost faith in the company, and sold up their shares, shrinking the company even further (by way of draining REAL capital).  

Citation: Ruth D. Hines Financial accounting: In communicating reality, we construct reality; Accounting, Organizations and Society, 1988, vol. 13, issue 3, pages 251-261
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