John Kay on mark-to-market accounting

British economist John Kay has written another excellent, ungated column.

[A]ccounting standards – both IFRS [International Financial Reporting Standards] and the US Generally Accepted Accounting Principles – have moved from “prudence” towards “neutrality” and from “historic cost” to “fair value”. That emphasis implies insistence on marking trading assets to market prices. ….

Concern is often expressed about the difficulty of applying mark-to-market principles when there is no active market. Actually, the larger problem arises when there is an active market. ….

A contradiction lies at the heart of the efficient market hypothesis: if market prices did incorporate all available information about the value of an asset, no one would have an incentive to obtain that information in the first place. The perverse implication of asserting that the market price of one’s assets measures their fair value is that the people best placed to supply information about fair value – the owners – abandon the attempt to make such an assessment in favour of the judgment of traders. And this is not an academic quibble: what happened at Enron, and in the banks, was that trading assets were marked to values that had been established not by people who knew about the contracts or the loans, but by the biased and ill-informed assessments of the traders [my emphasis].

To express reservations about the primacy of mark-to-market principles is not to say that assets are best valued at historic cost. Market prices may often provide insights of relevance to managers and investors. But one can acknowledge that utility without adopting an ideological commitment to the infallible, or at least irrefutable, wisdom of the market. In the past decade, the efficient market hypothesis has been mugged by reality. ….

Accounts have many users and many purposes, and these vary with the nature of the business and the environment in which it operates. The nature and content of appropriate financial information should be a matter for negotiation between the companies that prepare accounts and the parties who use them.

John Kay, “The market is not the best place to set a fair price for assets“, Financial Times, 17 July, 2013.

The published version is available here (behind a metered paywall).

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