Objective, verifiable lies – and why we need them

by November 20, 2010

Like active duty soldiering, accounting is one of those peculiar occupations which is made up of long stretches of humdrum activity — at least this is how it appears to outsiders — punctuated by unpredictable moments of turmoil and fear. It’s the quiet calm of double-entry bookkeeping for year after year… and then it’s the collapse of Bear Stearns.

At moments like these, the attention of the world suddenly swings to accounting, and at about the same time the world realizes (or remembers) that it doesn’t understand much about it. Since learning is typically more useful if it happens before a crisis rather than during it, I’d like to introduce you to the most cogent and easy-to-understand description I’ve come across of why accountants value assets the way they do, and why financial statements are more like “impressionistic portraits” than statements of hard facts. Financial blogger Steve Randy Waldman, of Interfluidity:

In the United States, firm assets are initially valued at “cost”. Very simply, we say an asset is worth whatever a firm paid for it. For our machinery, that value is almost certainly “wrong”: If our expansion works out as planned, the equipment will have been much more valuable than its cost, and if our expansion turns out poorly cost will have been an overoptimistic estimate. The great virtue of “historical cost” is not that it is a good estimate, but that it is objectively measurable. Accounting conventions seem to prefer objective, verifiable lies to subjective truths! Is that dumb?

No, it’s not.

Read the whole thing here.