What is profit?

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I wrote a blog the other day entitled Modern Finance: Making Dividends out of Loans. Am American CPA seems to have take offence at my, admittedly, broad brush approach, saying:

What I am trying to do is verify that your claim has is based in fact. That's all.

Given that the financial sector represents 20% of the S&P 500, what you are claiming is the following:

1) All $2.4 trillion in profits are directly attributable to the financial sector of the S&P 500.
2) The remaining 80% of the S&P 500 had profits and losses netting to $0.
3) All of the $2.4 trillion in profits were a result of market-to-market gains.
4) The financial sector had, on a net basis, $0 in operating profit.

In other words, you're claiming that 100% of the S&P 500's profits for September 1, 2004 through September 30, 2008 were the result of mark-to-market accounting for marketable securities.

Those are extraordinary claims

Except of course that is not what I said at all and it is worrying that this accountant seems to think that mark to market accounting applies only to the financial sector.

Admittedly, I view this from a European perspective, and from that of International Financial Reporting Standards. But the whole basis of fair value accounting, as we would have it over here, has fundamentally reformed all reporting for all companies, and not just the financial sector.

In fact, so radical has the reform been that it seems to me that to very large degree what sector a company is in is now largely irrelevant to the form of reporting that it offers. The explanation is simple: if the purpose of financial reporting is, as both the International Accounting Standards Board and FASB contend, to supply information to the providers of capital to assist them in deciding how to allocate their resources, then financial reporting has no longer got anything to do with what the company actually does, and only has relevance to what opportunity it provides for making a rate of return within the financial marketplace. Everything in that circumstance has been reduced to one common denominator, which is how to make a quick buck.

Mark to market accounting is a fundamental element in this process: it enshrines the financial markets to which information is supplied by reporting entities within their own reporting systems, based on what I think the IASB thought was a virtuous circle, but which has transpired to be the very opposite.

And this mark to market process applies to a wide range of activity, not just to the marketable securities of financial institutions. As a result pension fund accounting has been fundamentally reformed; so too has been the accounting for goodwill (where write-offs mysteriously stopped almost overnight when this method of accounting was introduced). Property accounting was radically transformed, as was the accounting of the company for its own debt: the liability not now being the cash due but the market worth of the debt, which is something potentially quite different. I could go on, but the point is this: accounts before and after the introduction of fair value or mark to market accounting cannot be related to each other.

The fundamental difference is this. Under accruals accounting based on historical cost profit was accounted for in accordance with this equation:

Sales - Costs = Profit

Under fair value accounting profit is determined using this equation:

Net value stated at market worth at this year's balance sheet date - Net value stated at market worth at last year's balance sheet date = Profit

Yes, I do know I am simplifying things: of course I am, but that does not change the fundamental point: if you change the absolutely basic accounting equation on which you build your perception of profit the results before and after the change will not be the same. And that has been our experience. So radical is the change that before the change cash flow could basically reconcile one balance sheet with the next: now it need not. And if cash is no longer king then dividends can be manufactured artificially. They have been and we are paying the price for it. So are millions and millions of innocent investors.

Is that a cost the accounting profession should have imposed upon these people? I suggest not. But impose it it has. It has a lot to apologise for, and I'm not apologising for making the point.