The real cost of poor accounting

I recently wrote about the tangible consequences of the profits and losses that entrepreneurs in the economy make:

“When companies make a loss then, what goes missing from the economy is not money either… indeed, if under our present banking system this happens from time to time this is entirely incidental. More importantly, for human concerns, is the fact that loss making companies consume many more resources than they give back to the economy… The loss is not fictive or imaginary – it is not some wild hysteria or a lack of faith in the system – it is the loss of those real resources that the company consumes (steel, iron, health insurance and mathematical modelling services).”

However it must be remembered that the profits and losses that companies announce are estimated on the basis of the company’s accounts. These accounts will be maintained, and thus the profits and losses expressed, in monetary terms, and the ledger entries in theses accounts will contain monetary valuations of the various assets, liabilities, revenues and expenses relating to the company’s operations. 

In the absence of any significant inflation or deflation of the currency, these valuations will ordinarily be fairly accurate estimates of the relative values of the capital used to operate the company. For, the goods and services that make up the capital, income and expenses of companies will be purchased in markets and the monetary value of these things will be the result of a all of the market participants trying to outbid one another for available resources (such as land, labour, wood and steel). Different companies may pay different things for the same goods and some companies will abstain from purchasing goods that they consider too expensive at a price that is entirely acceptable to other companies that happily purchase at that same price (thus reflecting the fact that these goods have different values for different companies). However if the average price paid for a kilo of oak is higher than the average price paid for a kilo of steel then we can say that oak has a higher relative value, per kilo, than steel to the economic system as a whole. This is perhaps because it is preferred by consumers or perhaps because it is more scarce than steel. Regardless, it will indicate that oak can only economically be put to more important uses whereas steel might be used for purposes that were more mundane.

What if, however, we were to hack into the accounts of all of the companies in the nation and replace the prices that they actually purchased or sold steel for with some other random price? Surely their profit and loss statements at the end of the year would be much less accurate than they were before, would they not? If the price that we substituted into their accounts was lower than the price that they had actually paid then the companies that purchased steel would appear to be more profitable and the companies that sold steel would appear to be less profitable than they actually were. Such an accounting error might force some of the steel producers into liquidation, despite the fact that these companies were in reality entirely beneficial to the economy and producing much needed steel. Similarly, such an accounting error might prevent various companies that buy steel from realising that they were not profitable – with the result that these loss making entities would continue to consume real resources from the economy where it simply was not rational for them to do so, from the point of view of the economic system as a whole.

Even if the switcheroony that we performed with the steel prices didn’t cause any companies to liquidate entirely, it would certainly confuse the price signals in the market place such that steel producers were tricked into believing there was less demand for their product than was the case (thus cutting production) and such that steel consumers were tricked into believing there was more steel available than was the case (causing them to wastefully put steel to uneconomic uses).

The negative consequences of our meddling would therefore be twofold. On the one hand our actions would imbalance supply and demand and, if we were to continue to meddle with the company’s books over a long period of time, would eventually lead to a steel shortage. Secondly however, our actions would undermine the ability of companies (and thus the economy as a whole) to accurately gauge their profitability. Of the two side effects, this later could well be the more serious since it will cause ongoing long term real losses to society and the economy as a whole.

One of the primary costs of most companies, of course, is the cost of borrowing. However interest rates do not currently emerge naturally from a free and competitive market. Indeed, in as much as they concern our present discussion the price paid for savings by borrowers is set by central banks entirely arbitrarily. This is not to say the interest rates are set randomly without any consideration to current market conditions. However the relative preferences of consumers (borrowers) and producers (savers) are entirely ignored by central banks when setting interest rates and even the relative scarcity or abundance of real savings in the market place, it seems, is paid very little heed. Primarily what motivates central banks in setting interest rates today is a peculiar Keynesian notion of full employment and, as though the two were somehow diametrically opposed, a “watchful eye” on inflation to balance this.

The fundamental meaning of the accounting concept of profitability, it seems, does not even enter into the equation. Certainly attention is paid to broad statistics such as the CPI, PPI and the GDP. However the fact that interest rates – one of the primary costs incurred by every entrepreneur in the economy – are not an accurate reflection of the real costs of borrowing both to companies and to the economy as a whole means that the ability of every entrepreneur and every borrower in the economy to gauge their profitability has been severely undermined, in real terms. Hence the ability of central banks to calculate the profitability of the economy as a whole and the relevance of statistics such as the GDP is also undermined (even if these statistics were accurate – which is rather doubtful considering the methods currently used to calculate both inflation and the GDP).

What this means is that the normal mechanisms for ensuring that only profitable activities take place (i.e. liquidation and bankruptcy) and that production remains positive with respect to consumption are not working properly. There are millions (perhaps billions) of entrepreneurs all over the planet making what they believe to be profits when in fact these entrepreneurs are a burden to the societies that they live in – consuming scarce savings of real resources which are, as a consequence, no longer available to be put to truly profitable uses. In wasting those resources, the societies that employ central banks have prevented the existence of countless profitable companies that most certainly otherwise would have existed and which, far from being a burden on our societies, would have enriched them and employed just as many people (if not more) than the unprofitable companies resulting from a misguided Keynesian “full employment” policy.

Fundamentally the fault of central banks is that they do not focus on that which should be the focus of all economics – the satisfaction of human needs. Instead they focus on the much narrower goals of the “need for employment”. And in their pursuit of that narrower goal they disregard entirely whether or not the “employment” that they seek to encourage is profitable or not, and thus whether or not their actions (even should they succeed in realising the desired objective) will be good or bad for the economy.

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