I think this might be one of the most important videos I have ever made. I know the issue is complicated, but it's worth taking the time to watch it or read this post. 

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Most people think accounting records what has already happened: profits earned, cash received, assets owned, and liabilities owed. But that is no longer how much of modern accounting works.

In this video, I explain how accounting has been transformed from a system based on prudence and evidence into one that increasingly relies on expectations about the future. Using a simple example, I show how an investment purchased for £10,000 can be valued at £20,000 almost immediately, even though no additional cash has been received and no profit has actually been earned.

The key to understanding this process is discounting. Future cash flows are brought back into the present using an assumed discount rate, creating a present value that accounting often treats as if it were real wealth today.

As a result, expected future gains can be recognised now, long before they have actually occurred.

In effect, accounting creates a financial time machine, importing the future into the present and treating estimates and assumptions as if they were facts.

I explain how this logic underpins mark-to-market accounting, why it became embedded in global accounting standards, and why it represents a profound break with the traditional accounting principle of prudence, under which profits could not be anticipated, but losses had to be recognised as soon as they became likely.

But this, as I explain,  is about far more than accounting rules.

The same logic shapes financial markets, share prices, pension funds, investment decisions and corporate behaviour. Tomorrow's income becomes today's wealth, and future possibilities become present-day profits.

I argue that this process inflates reported wealth, reinforces inequality, redistributes power towards those who own financial assets, and even affects how we think about issues such as climate change, where future costs can be discounted until they appear almost insignificant.

The result is a financial system that often presents uncertainty as certainty and speculation as fact.

So is modern accounting providing a true and fair view of economic reality? Or has it become a mechanism for claiming ownership of a future that does not yet exist?

That is the question at the heart of this video.

This is the audio version:

The Debate Ammunition for this video is available here.

This is the transcript:

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I have a confession to make. I became an accountant in 1982. But the fact is that most people do not understand accounting, or at least accounting as it now is.

They imagine it looks backwards and records profits already earned and assets in ownership.

But modern accounting does something completely different to that. It reaches into the future, takes values that do not yet exist and brings them back into the present as if they exist now. In a very real sense, it creates a time machine and that time machine is dangerous.

To understand modern finance, we need to understand how that trickery works. An example will help. I made these numbers up. They are purely for demonstration purposes, but accept them on that basis.

Imagine I am offered an investment today, and I'm asked to pay £10,000 for it. I'm buying some form of bond, or investment, or share; it doesn't really matter which. What I'm told is that this investment will pay me £2,000 a year for the next three years. And then I'm led to believe that I will be able to sell it in three years' time for £20,000 because, in the meantime, proof of concept of this idea will have been established, and so its value will double from what it appears to be today.

The question is a simple one. If I'm running a company, what is this investment worth today, and how do I display it on my accounts?

The answer that accounting gives is not the answer that most people would expect, and that reveals the trickery within modern accounting.

Most people would start by adding up the money. In this case, there are going to be three payments of £2,000 coming in, and we're going to expect sale proceeds of £20,000. So the investment appears likely to generate at least £26,000 in cash, but that is not the number that accounting uses for the valuation of this asset.

Why does accounting refuse to use that figure? That is an important question, and the answer is that accounting says that money received in the future is worth less than money received today is worth. A discount rate is therefore chosen to adjust future values, and that word discount is important. We do discount the future.

Now, an example will help. Assume that the discount rate we use is 10%. I stress, again, this is just an assumption to make the numbers easier to see. Every future cash flow is then reduced in value by 10% for each year it's delayed by. That is the point of discounting. It reduces the value of future income streams by a set percentage to allow for the fact that they aren't being received today, but are being received sometime in the future. But we assume that there is a current worth at this moment to that money that will be received sometime, not now, but at some time in the future.

The future is literally translated then, or discounted, into present values.

The £2,000 due in one year becomes £1,818 today. That's because the £2,000 is divided by 1.1, which is 100% plus the 10% discount rate.

And then the £2,000 due in two years' time becomes worth £1,653 today. That's £2,000 divided by 1.1 squared to allow for the fact that we're receiving this in two years time, and on the same basis, the £2,000 due in three years time becomes worth £1,503 today, and the £20,000 sale price shrinks to just over £15,000. Accounting is steadily pulling back the future into the present.

Add all those numbers up, and by pure chance, they come to almost exactly £20,000. Now, I'll be honest, I made these numbers up, and I had no idea I would create such a perfect round number outcome. I'm good with numbers, but not that good. But what I've shown is that in current terms, using these accounting conventions, I have got a figure that is double my initial investment of £10,000. That income stream that we have discounted from the future produces an outcome which is supposedly worth £20,000 now compared to an investment that only cost £10,000.

Now, here's the key thing. Accounting says I can use that £20,000 valuation now in my accounts. This is the logic of what is called mark-to-market accounting, and that has been included in all the accounts of all the world's major companies since 2005.

In other words, it is said that there is a gain on this investment now of £10,000. We brought back from the future into the present, the value of the cash flows we expect to receive, not the value of the cash flows that we know we will receive, using a discount rate that we decided upon, and we've created a situation where we claim that we have got a result

a gain of £10,000.

And that gain accounting says exists today. It's the reward for being so clever that we bought this asset, which is going to make a future profit for us. The profit is not going to arise now because we know it's going to arise in the future, but nonetheless, accounting lets us claim it at the present point of time, and that is the time machine trickery that I'm talking about.

And this is where the story becomes fascinating.

No cash has been received as yet.

No income has actually been earned, and the future of payments remains uncertain.

I'm told I'm going to get £2,000 a year.

I'm told I'm going to sell this asset for £20,000, but no one can actually guarantee these cash flows, all of which I stress are estimated.

But accounting still says that a gain can be recorded as if it exists, and that can be recognised in our accounts. And supposedly reliable auditors will certify the accounts as true and fair, even though they include this wholly made-up number.

And let's not pretend otherwise, this is a wholly made-up number. It's based upon estimates. It's based upon an assumed rate of return, not a real one. And it is based upon a mathematical calculation, which looks spuriously accurate, but in practice is just a load of gobbledygook. It takes assumptions and turns them into what looks like a reality, and then supposedly clever people, otherwise called auditors, say they are true and fair. But are they? I don't think so. You'll have to make your own mind up on that.

This, though, is what modern accounting does. Modern accounting is not only interested in cash. It's also interested in the expected economic benefits of current actions. So it can claim that an asset, which I've only just bought for £10,000, is actually worth £20,000. And the claim that accounting recognises is that wealth has been created as a consequence of my wisdom in buying this asset, even though that wisdom is all based on guesswork. And the bizarre claim is that the gain arises at the moment of purchase.

Future cash flows merely confirm what accounting already believes to be true, in other words.

Future accounting will recognise additional income. Let's be clear about that. The difference between the £20,000 that we recognise now and the £26,000 of cash flows earned will be recognised in future accounts, but as if they are the unwinding of the discounted interest implicit in the calculation that gave rise to the £20,000 valuation now. And so they will be much reduced from the actual cash flows received at that time.

And this, I stress, is the total opposite of prudence. Prudence was once the defining characteristic of accounts. They were cautious, and profit was never anticipated, come what may.

You were required to anticipate losses because that was prudent. In other words, if you could see that a debt you had outstanding was not going to be paid, you wrote it off now and not when it actually failed. And if you could see that the value of an investment was going to fall or had fallen, you would allow for that fact in your accounts as well. But if the value of an asset had gone up, but you had not yet proved that by selling it, you could not anticipate the profit. That was the old rule. But that's not the rule now.

In 2005, there was a neoliberal revolution in accounting, which let it claim the future as if it existed in the present, and that is not true, but that is how much of modern accounting portrays itself. It claims certainty about the future, when no such thing exists.

And it is this make-believe world that is the supposed intellectual foundation of much of modern finance. Financial markets are built on expectations about the future. Shares, bonds, derivatives, and other property are all valued in this way, and future possibilities are turned into present prices.

The financial world is, as a result, a world constructed from forecasts and assumptions and not from truth. This means that something deeper is going on here, though, and that is really important.

Income that has not yet been earned becomes wealth today. Tomorrow's gains become today's profits. Future opportunities are incorporated into present valuations, and in effect, finance appropriates the future into current wealth and brings it into the present. And that is done for one reason, and one reason alone. It is done to increase the statement of current wealth, and that is being used to increase stated inequality. Power is being redistributed by accounting as a consequence.

And none of this is merely a technical accounting exercise.

Discounting shapes investment decisions throughout society.

It influences stock markets, pension funds, and government policy.

It even affects how we think about climate change in future generations. We don't worry about climate change because we can discount it. The costs of climate change are so far in the future, they become almost worthless in this accounting methodology.

The discount rate apparently becomes a statement about how much we value the future itself, and in far too many cases, we don't value it enough.

And, staggeringly, uncertainty is removed from view by this method of accounting. Apparently, certain figures based on what might be very dubious assumptions become reality when they are printed in accounts as profit or on balance sheets as wealth. But they're all just made up, never forget it.

The fact is, modern finance depends upon this accounting view of time. It assumes that future benefits can be measured and valued today. Entire markets are built upon that assumption.

But perhaps we should be asking whether the future is really something that could be bought, sold, and consumed in advance, because once we understand discounting, we begin to understand how finance has come to dominate our thinking about that future, and it's not for the better.

This time machine is just a fiction of somebody's imagination, a spuriously accurate mathematical formulation of data, highly likely to be wrong. But dividends, directors' bonuses, although not always taxed, are paid on the basis of these made-up numbers that are used to overstate current wealth by borrowing it from the future.

Remember, we have to pay to borrow and repay it in the future. The wealthy are doing something very different. They're borrowing the future and rewarding themselves today for doing so, and they're doing that in plain sight. And the future they're taking, well, that's ours, of course.

Our future is being stolen by accountants who claim it is in the ownership of the wealthy. It isn't. It's ours to enjoy, and that's why this method of accounting is so fundamentally dangerous and has created so many distortions in our society over the last two decades.

That's my opinion. You may not share it. There's a poll down below. Please leave us your comments, and if you like this video, please indicate that fact. Please do subscribe to our channel as well. And if you're so inclined and want to buy us a coffee to encourage us to keep on making videos like this, we'd be very grateful because this member of the team, at least, is a bit of a coffee addict. Thank you.

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