Richard Bookstaber and the Curse of Squishy Numbers

Richard Bookstaber explains some hard facts about accounting that I thought I understood but which I understand much  better having read Richard Bookstaber:

The [19th Century] railroads depended on public financing and needed a means of assuring investors that their money was at home under a positive stewardship. They had accountants run through their books and then made their finances known through business journals. ...  Standardization of accounting methods also came about through the demands of railroad accounting. ... After the crash of 1929, the Securities and Exchange Commission (SEC) mandated that these standards be applied ton all public corporations. This mandate persists today, but as often as not, the SEC is mandating the reporting of irrelevant information.

The orientation that accounting took for railroads was, not surprisingly, focused on the assets of the company—the track and rolling stock, along with the deprecation of capital—rather than earnings. Value was defined simply as the cost of the assets less the depreciation of the assets over time. This orientation carried through smoothly to other industries of the era, principally manufacturing and transportation, where cost could be used as an index of value.

For real assets such as physical plant, assembly lines, machinery, and real estate, valuation in terms of costs is logical: a business can reproduce the enterprise by simply going out and buying each of the component parts that constitute the production process. But the relationship between the cost of assets and the value of the enterprise does not work as well for companies with intangible assets, and these increasingly form the basis of economic value today. Intangible assets—ideas, patents, proprietary software, brand names, trade secrets, trademarks, and copyrights—have value that cannot be extracted from their costs.

The reach of intangibles is extensive; as Charles Leadbeater has said, “modern corn is 80 percent science and 20 percent corn,” alluding to the extensive lab development behind hybrid corn seed. By some estimates, intangible assets now make up 80 percent of the value of the S&P 500. They are what provide companies with their franchise value, sometimes bordering on monopolistic market position. Intangible assets are the product of imaginative people who walk out the door every night; others are formulas locked in a vault. And in many cases, once they have been created and the intellectual property has been claimed, they cannot be reproduced at any price.

One simple indication that the current accounting conventions do not reflect the actual value of the enterprise is the disconnect that has appeared between market and book value. In the industrial era of the railroads, market value was all but defined by book value. If market value moved above book value, you would simply create the same enterprise for less money by replacing it brick by brick. The market-to-book ration stayed near one-to-one through the 1970s, but since the 1980s has slowly moved up. The ratio in the mid-1990s was on average about three-to-one, and shot up to six-to-one by the end of the decade. The extreme is in part due to the euphoria of the Internet bubble, but the ratio has been out of its classic balance for the better part of two decades, more than can reasonably be ascribed to a market disequilibrium.

That's from Bookstaber's A Demon of Our Own Design, which I'm just getting around to now a couple of years late; nonetheless one of the most helpful items I've encountered for understanding our current plight--I hope to say more about it later.  For the moment, let me expand on his point this way: I wonder if one of the reasons why accounting has become so corrupt in recent years is the lack of the kind of firm, well-defined asset values you could look to in an era of iron and steel: if you were measuring as locomotive, you pretty much knew its market value.  In these days of squishy and inimitable asset values--patent rights, trade secrets, the works, you have fewer firm points of reference.  It makes it all the easier to yield the management pressure and just go with the numbers that management wants.

Oh, and one more thing I learned from Bookstaber.  You remember Luca Pacioli, the father of accounting?  Sure you do.  Anyway, he was from Borgo San Sepolcro, home of the great Renaissance painter, Piero della Francesca.  And apparently Pacioli appears as one of the saints in Piero's "Madonna with Saints" at the Brea in Milan (though there seems to be some uncertainty as to just which one).