It's been easy to be lost in the present during lockdown. The immediacy of news on cases, deaths, and political failings in the face of the very obvious need for decision making on actions that appear to be required has led to a focus on the moment. And in many cases that has been appropriate. But I have to keep reminding myself that this is also not all that life is about. Whilst being present is important, and a focus on the moment can be necessary, there is also a future that has to be looked for. And yet that is all too often forgotten.
There is an obvious relationship between past experience, which inevitably taints us, whether for good or not, the present moment, and our hopes for what is to come. It is one that has become deeply confused, most especially with regard to the present. It is easy to witness this. The past has become the basis for recrimination within the political domain. The present is, all too often, the place where unsubstantiated claims are located, in the hope that memory might be short. And as for the future? Where is that? If the past is another country, then all too often it seems that the future is a place where we will not venture.
There might be good reason for that far of adventure at this moment. If the recent past is what determines much of our trajectory, at least as far as thinking goes, then the future does not seem very inviting right now. The prospect of a world more extreme, intolerant, and even uninhabitable, is not one that people want to embrace. It is all too easy to recoil from it. But that only plays into the hands of the extremist who wants to occupy the space we might want to vacate.
There are other reasons why we do not consider the future. For example, for the last few decades economists have pretended it does not exist. They use a method called discounting to evaluate all future consequences of current behaviour with aim of ascribing to that future a value in the present. They do this by literally ‘discounting' the financial consequences of those decisions to the present using a risk weighted interest rate. It is claimed that this produces objective current decision making. Supposedly rational organisations use this approach, accepting its implicit assumptions.
One of those is that we can actually predict what is going to happen. That's just wrong, of course. But that has never stopped an economist making an assumption.
The other is that we are actually indifferent as to when things might happen. This is much more troubling. What the theory of discounting implies is that I am indifferent between a relatively modestly good thing happening in a year's time compared to a monumental event in ten or more years time, presuming the assumed discount rate can literally equate the two to a similar value now. And that is just not true either.
As a matter of fact there are good things that I definitely want to happen in the future that are decidedly time critical, for my family for example. And some of them I would definitely not wish for now.
But there are also events that I know that are not possible now that might be in the future and which I know I wish to be achieved by certain points in time. Take carbon neutrality, for example. I know it is not possible now. I put enormous stores on the fact that it may be possible in the future. I am not going to take comfort now from some mathematical model that tells me that I can be happy at this moment that carbon neutrality might be possible in the future, and may increase my wellbeing if it is. I want to know that there is a concrete plan of action to achieve that goal, and the two are not the same thing, at all.
It's worse than that, in fact. The mathematical model can provide a perverse incentive to delay, by diminishing future cost and so enhancing current supposed well-being by simply pushing back the time when a required action takes place, when in practice we know that taking action now really is a matter of the highest priority if the goal is to be achieved.
The Covid crisis has demonstrated the negative consequences of deferring action in the moment. Our government has been a master of doing so. Almost every decision it has taken has either been too late, and so future consequences have been worse than they might be (e.g. every lock down date) or too early (e.g. every lock down release date, inducing the one upcoming) and always because they have sought to dismiss future cost for current gain by applying a massive discount to future Covid risk. If they had just been willing to listen to narratives that embraced any point in time other than the present, in which they think all their political advantage is located, they would have made decisions that were so much better than those that they did.
And this is also true of climate change. There discounting cannot work. It encourages deferred action when what is required is current activity if this crisis is to be beaten.
The means to address this false logic of discounted decision making are the focus within the Time Mirror academic project, funded by the Danish government, in which I am taking part over the next four years. Explicitly exploring the idea of sustainable cost accounting, which I have created, as a means for addressing this issue the project will look at why discounting would hinder effective accounting decision making on climate change, not least within the private sector economy where a massive behavioural transformation is very clearly required.
Sustainable cost accounting demands that companies put the costs of achieving net carbon zero on their balance sheets upfront. It challenges the logic of not disclosing the potential costs upfront and in full, and accounting for them on a deferred, drip feed, basis instead. It says that in this case the future must be addressed now by provisioning on company balance sheets the full expense thought likely to be incurred and that the plan for action must be explicit in the present, even if it can only occur in the future, at which point outcomes against stated expectations must be compared and consequences be accounted for.
This is radical accounting. I am pleased that the opportunity to explore it in more depth is being provided. But the lesson is not just for accounting, or climate change. The logic says that you cannot discount the future in the present. It says instead that we must embrace the future, and the actions that we might wish for as activities that are as relevant to the moment as they might be at the time that they occur.
We would not unlock early for the sake of a meal out if we did that.
We would condemn more strongly those who undermine the democratic foundations of our state if we did that.
We might also invest and not speculate for short term gain if we did that.
Embracing the future has massive current consequences. It is what we need to do, but we are so poor at thinking about the future as a result of the training in indifference that we have been given that we, and most especially our politicians, rarely take into account foreseeable events that might happen in only a few months time, and literally discount them instead. And that is both shocking, and as we now know, deeply costly.
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Keep pounding away furiously with your Danish project on emissions. We need to get away from those who want to price them in; who want to leave it to markets because they personally know the price of nothing and the value of everything. I look forward to cracking a read of the paper out in a spare 20 minutes one day.
It would help your argument if you understood what discounting is. You get it completely wrong.
Discounting is not used to predict the future, as you seem to think it does.
All discounting is is taking a series of future cashflows and using current interest rates valuing them at today’s prices. By definition, this means the present value of these cashflows can change if interest rates do.
For example, if there is a cashflow in ten years time, and I discount it to today’s present value, I am making NO predictions on it’s future value. I am only saying what that future cashflow is worth today, based on the observable interest rate used to discount it today. If interest rates rise, that cashflow will be worth a lot less.
I would have thought an accounting expert and economics Professor three times over would know this.
I never said discounting predicts the future
I said it dismisses it using exactly the methods you describe
But as I also noted, which you did nit, not only can you not predict the future or future interest rates with any certainty, we actually have time preference as to when things should happen
Thank you fir proving there are fools who believe this is useful despite these failings
“They use a method called discounting to evaluate all future consequences of current behaviour with aim of ascribing to that future a value in the present.”
Is what you said about discounting. I.e. predicting the future.
Present value discounting makes literally ZERO assumptions about the future. It ONLY uses observable rates to calculate the present value of a future cashflow. It is a measurement, not a prediction.
To not understand this is quite idiotic.
But I suppose you have a better way of valuing future cash flows?
With respect, if you think making forecasts about cash flows that might arise in the future is not making @n assumption about that future then I think you have some really serious things to learn.
I actually am quite genuinely sorry you cannot see quite how stupid that claim is
Future cashflows are contractual in nature. There is no guessing about them. So their nominal future value is known. This is true for every fixed income product, including bonds.
As an accounting expert, I would have thought you would know this.
But please, do tell us how you would account for future cashflows without discounting? Would you put them on the accounts at face value? Or just not put them on the accounts at all?
I am genuinely quite sorry you cannot see how stupid your claims are. Discounting requires no prediction of the future and no assumption whatsoever – because it tells you nothing about the future at all.
With the greatest of respect, that is the tiniest use of discounting in accounting, which is what I was referring to.
Accounting uses discounting to appraise the value of ‘cash generating units’. Let’s simplify that and call them the income streams from businesses that a parent entity has acquired and now needs to value for the purpose of ensuring that the goodwill on its balance sheet associated with its acquisition is still fairly stated. This involves the valuation of a highly uncertain income stream using discounting. But it would seem that you are quite unaware if this, and yet it was that to which I was referring.
Let me assure you, however, that every single aspect of this valuation is assumption laden.
So, with respect, you quite literally could not be more wrong.
Once again, you are showing a lack of knowledge and understanding.
Uncertain future income streams do not form part of accounts. Only contractual obligations do. You don’t account for income you might earn, only that which you will contractually earn. I assume you don’t put income you haven’t earn;t yet from contracts you don’t have yet into your own company accounts?
You are trying to conflate this with company valuation, where various factors will affect the goodwill term, but ultimately it is an intangible asset reflecting the excess purchase price of a company – calculated purely by taking the purchase price of the company and subtracting the net asset/liability position. There is no discounting when it comes to goodwill – it can ONLY be impaired under IFRS, and is always a present value term which needs no discounting.
Either way, discounting is not subjective, being a purely mathematical way of representing future cashflows in present value terms. Even if you take something subjective, in terms of trying to estimate future revenues, the discounting of those revenues is not subjective. Those cash flows are discounted back at market interest rates – normally using the risk free/government curve.
So, no not every aspect of valuation is assumption laden. Though it seems that in what little work of yours I have read you are more than happy to make estimates and assumptions and then claim they are 100% accurate.
But I ask again, if discounting is so wrong, what would you do instead for the treatment of future cashflows?
With respect, you literally could not be ore wrong. In literally everything you have said. It just shows a total lack of understanding – one which suggests you are not fit to practice as an accountant.
I am sorry that you are so misinformed
Please read IAS 36 https://www.iasplus.com/en/standards/ias/ias36
Then read IFRS 13 on fair value https://www.iasplus.com/en/standards/ifrs/ifrs13
And note that the income approach in the latter suggests:
income approach — converts future amounts (cash flows or income and expenses) to a single current (discounted) amount, reflecting current market expectations about those future amounts.
In other words, the future estimated income stream of a cash generating unit us used to estimate its fair value carrying amount in the accounts – meaning quite emphatically that future income is taken into account in current accounting. There are other examples available.
I object to that, but at least I do so on an informed basis, including the fact that this effectively double counts income.
You object in the basis of ignorance. I suggest you don’t call again unless it is to apologise.
I’m curious Richard, is this discounting used to value income streams from things like fossil fuels too?
Yes
It would be used to help value reserves, and assumptions on stranded assets would be key to this
I’m getting concerned that you really don’t know your accounting.
IAS36 deals with impairment and recovery values of intangible and non-current assets. The only part of IAS36 where you would have to estimate future cash flows is IAS36.30, or Value in Use. It is almost never used, and when it is only to try and value something that can’t be valued through fair value or recovery values. AND even then the discounting part of the calculation is NOT an estimate. Clearly you haven’t actually done any real world accounting for 20 or more years.
IFRS13 deals with Fair value or Mark to Market valuation. You quote the following:
“income approach — converts future amounts (cash flows or income and expenses) to a single current (discounted) amount, reflecting current market expectations about those future amounts.”
Then make yourself look like an idiot by saying this:
“In other words, the future estimated income stream of a cash generating unit us used to estimate its fair value carrying amount in the accounts — meaning quite emphatically that future income is taken into account in current accounting. There are other examples available.”
No, no, just no. You do NOT estimate and account for unknown future income streams in IFRS13. You DO account for known future cash flows if they are contractual, for example a contract to sell something in the future. You then discount those future values by market interest rates to account for them in present value terms, so all values can be compared on the same basis.
I ask you again, do you put revenues from contracts you don’t actually have yet in your accounts for your company?
And if you do not use discounting, how are you going to treat future values? Carry them at book? Ignore them?
You keep refusing to answer these questions – I think mostly because you’ve already dug yourself a hole and any answer you give will make you look like more of a fool.
Hang on a minute here
A comment or so ago discounting had no role in accounting – ever – and it was all contractual
But now you concede that I was right on that issue, and of course discounting has a role. But now it’s just hardly ever used
Who does not know their accounting then?
And as for the claim that IAS 36 does not involve estimates, politely, might you stop being silly?> It’s all about estimates, from the interest rate onwards. And there is only one risk-free asset, which is government bonds from a country like the UK, so every other forecast involves recovery assumptions. Politely, being crass does not help your case.
And if you are not aware of it, there is no market for most financial instruments because they are tailor-made over the counter – and often performance-related or conditional – so discounting, and assumptions are used in the valuation of many of them. Again, your claim is wildly inaccurate that market value can be used – because market values are rare.
And as for impairment of goodwill that is all about estimating future trading performance – exactly as I said. And since the asset in question cannot be for sale unless it is claimed purchase price is market worth (rarely a tenable claim after a year or two, although often made) of course estimated discount rates are applied to estimated cash flows. And yes, the assumptions include unknown future sources of revenue – or there would be almost 100% goodwill impairment on acquisition in almost every case, glaringly obviously.
This exchange is over. You have not a clue what you are talking about. Thankfully, I have.
I’m sorry but you are now flat out lying, both about hat I said and about accounting standards – which you clearly do not understand.
I said that discounting is not subjective. No estimates are involved. This is because discounting uses market rates, which are observable – usually the government bond curve.
“But now it’s just hardly ever used”
All future cashflows are discounted.
“It’s all about estimates, from the interest rate onwards.”
Interest rates are not estimated. They are the observable market rates, as mentioned above. Or are liquid, market traded instruments such as government bonds now estimated as well?
“And if you are not aware of it, there is no market for most financial instruments because they are tailor-made over the counter”
Never heard something so stupid in my life. OTC instruments are traded in huge volumes, again with observable pricing. More complex derivatives can be broken down into component form and valued. Valuing OTc financial instruments are relatively easy to value, and it is done on a mark to market basis.
“And as for impairment of goodwill that is all about estimating future trading performance — exactly as I said.”
Goodwill has NOTHING to do with future trading performance. It is ONLY an intangible asset that accounts for the excess purchase price of a company over it’s net tangible assets. This is VERY basic accounting.
Impairment of Goodwill depends only on the carrying amount and the fair value of assets in a business unit. There is no input from estimating future trading revenue. Again, if you understood accounting or IAS36 you would know this. As it is, you are just making things up.
But please, show me somewhere in the accounting standards that says future estimate trading revenues should be calculated and form part of the goodwill accounting term. Go on. Try.
Again, you can’t or won’t answer how you would treat future values, or if you would put unknown future revenues in your accounts.
I think this is because you actually don’t really have much understanding of accounting, and are essentially making things up as you go along. Based on what I have seen you should not practice, would fail current accounting exams and the things you are saying would be actionable in terms of the incorrect information you are giving.
With the very greatest of respect, very large numbers of financial instruments can only be valued by modelling because there is no open market value, and those models are always subjective. If they weren’t there would be no risk in financial markets and we do, of course, know there is. As such what you are saying is simple nonsense. My case is emphatically right.
As it is on goodwill amortisation which has a carrying value only because of its future value and not historic cost (which you seem unaware of). An imnp[airment review will always require a review of future trading, and discounting to the present, of course.
With respect, you really do need to learn some accounting.
And you are now banned from this site.
I’m going to send a copy of this thread to the Financial Reporting Council. We can’t have practicing accountants making such basic errors such as Jon has no doubt incorrectly implied that you have made Richard. People like this need to be investigated as errors such as this can’t go unpunished
Go ahead
They do not regulate me
And they will laugh themselves silly at the suggestions made by Jon, which as I evidenced are entirely wrong
Don’t worry – if the FRC won’t have a look at it i’m sure the ICAEW will.
I’ve sent a copy of this along with various other bits of Murphy’s made up accounting nonsense to them – along with examples of the abuse and bile he puts about this site in a wholly unprofessional manner.
Feel free
The problem for you is that I am right on the accounting
And I think they know about my style
I am their #1 accountant on social media, two years in a row
Fascinating. I await with interest the outcome of this. Especially how it would impact on individual organisations and their reporting.
Craig
I hope it will…..
Well said Richard. The theory of discounting is based on the fallacy that money is immutable, that it always carries the same value (which can be discounted against) and will always have the same purpose. It sees history as a repeated frame in a videotape..for ever frozen in an ever repeating future. Of course we know that is not what history is so
this narrative is one big fairy tale we are told to hold us in bondage to the financial elites. We might as well believe that the universe was created in 6 days with the 7th used for a breather.
Re your final paragraph, I would suggest that not only do politicians discount foreseeable future events they ignore the precautionary principle which might have some relevance in considering such things as easing of lockdown and wheezes like “eat out”. Nor do they think about what might be the consequences of an error of judgement – people might put more money into restaurants but if that increased infection rates and deaths are we any better off or are deaths and the burden on the NHS worse than not getting people to spend when the government could just put the money in anyway?
Companies should be thinking along similar lines.
Agreed!
While it isn’t something that can be expressed by accountancy, I have to admire those Aristocrats who were willing to splurge massive sums of money on tree planting and landscaping that they knew only their heirs would see in its completed form.
Todays senior managers and politicians need to asking what will the world that they are creatring be like in a century or so.
It may have been paid for with the proceeds of slavery, but it showed a certain sort of vision
I have a good degree in Accounting and Finance and am qualified as a CIPFA accountant (retd) . I spent most of my career in healthcare and it was an oft repeated phrase that the NHS doesn’t know how much things cost and therefore cannot be in a position to allocate its resources sensibly.
Having read my costing text books I would reply there are 131 different versions of costs depending on the nature of the decision required. Which one do you want?
I would visit the HM Treasury and argue for more resources to be allocated for hospital rebuilding. I explained that the money allocated at the time wasn’t enough to pay for the immediate replacements of X ray tubes needed to keep hospitals functioning on a day to day basis let alone to replace old hospitals for new.
I thus dabbled in PFI funding of hospitals where we all pretended that the “savings” available from new hospitals was greater than they were , the banks pretended that the “risks ” inherent in building new hospitals was greater than it is , and we all used a very high discount rate (according to the Treasury rules) for future costs that made it look like it all added up.
It was all nonsense but hospitals got built.
You quickly learn in healthcare that an ethical framework is required for decision making, (it was my job to console the Renal physicians whose job it was to tell anyone over the age of 60 that they were not eligible (at the time) for treatment as they were too old, and to tell the heart surgeons how many operations they could do that month); but you learn from history of the British Empire that the lives of natives are not as important as Brits and that entire species can be wiped out if the benefits are great enough. The human race has gone ever further down the food chain from whales, fish, buffalo , pigeons, oysters; to now -insects , the wrong sort of vegetation and the soil – until now it is the air we breath , the safety of our shores and climate change itself that threatens to wipe many people out.
Sustainable costing is all very well but if we live in an unethical world where the living and wealthy can claim the wealth of future and past generations to justify genocide, repression, gross inequality, the burning of the rain forests, desertification of the sea beds etc. ,we need to ask the relevance of our task.
Contingency theory (https://www.sciencedirect.com/topics/economics-econometrics-and-finance/contingency-theory) teaches that solutions are relative to the nature of the task.
Sustainable costing seems to justify a belief that accurate costing will lead to the right decisions being made on the allocation of resources.
But just as the NHS has discovered ; that it is possible to cost (or more accurately price ) each patient episode according to the correct diagnosis of the disease and categorisation of the treatment ; it merely becomes a cost in itself if the big decisions (on whether healthcare is a public good or private good; or whether universal good quality healthcare represents a desirable goal if it raises taxation levels or whether some people should die sooner to help others who will not) are unaffected.
Hence carbon pricing systems have become yet another market, little understood and manipulatable, that has created jobs for accountants and regulators while doing little to promote action to prevent climate change. I attach an attempt to theorise why such systems have failed and why they no longer fit the circumstances :
https://www.sciencedirect.com/science/article/pii/S2542435118305671
This describes that the time for tinkering is over.
I suggest you shift the thrust of your sustainable costing project to transitional costing. This implies that regulators have to identify the changes they want and then to apply the necessary incentives and penalties to achieve it.
Many will not like it , but that’s the point.
And if you want that described in discounting terms the costs of investment in measures to affect climate change should be funded from the Climate change Bank paid for by the future benefits accrued to the bank , calculated as the receipts
attributable to the investment . in other words the notional benefit of measures to control climate change should be monetized to fund the immediate investment required to affect climate change: the value of immediate investment is equal to the benefits that will accrue over time as calculated and vouched by the Climate Change Bank.
Sustainable cost accounting is not about carbon pricing
It is literally only about transition costs, as you suggest
I think you have misread it – what you ant is what I am offering
Apologies for jumping to conclusions. I hadn’t read it as It is yet to be issued and I confess that costing can imply the belief that tinkering with pricing systems (as in carbon pricing and in the NHS) is enough in itself.
But pleased that we are on the same wave length on transition costing.
I await your future work with interest.
Signs if shifts in mood, you may get a better reception on this than you expect.
https://www.theguardian.com/business/2021/feb/17/oil-firms-should-disclose-carbon-output-says-blackrock