Economical Equilibrium

by Ilya Kuntsevich

  Let’s challenge fair value. The Reserve Primary Fund, the oldest money fund, made headlines in 2008 when it "broke the buck" as a result of owning too much debt issued by Lehman Brothers. The Primary Fund, which had assets of $63 billion at the time, held just $785 million in Lehman-issued securities – about 1.25% of the fund's total assets. But investors got spooked and withdrew their money in droves, leaving the fund unable to meet redemptions. The next day, the fund announced that its net asset value had fallen to 97 cents. The timing of these events was between Monday, September 15, 2008, when it filed for bankruptcy and Tuesday, September 16, 2008, when Reserve Primary Fund’s shares fell to 97 cents after writing off debt issued by Lehman Brothers. The Reserve Primary Fund has since been liquidated and its parent, the Reserve Management Co., was charged with fraud and misleading investors.

  If we were to use “objective market data” on the Reserve Primary Fund’s stock price, as required by GAAP, we would get two drastically different “fair values” within 24 hours. This would also be the case during the flash crash of May 6, 2010, when one trillion US Dollars of market value disappeared within half an hour. Both events had nothing to do with the monetary (cash) or fundamental valuation of the companies. Going back to one of John Keynes’ famous quotations: “Markets can remain irrational longer than you can remain solvent”, why would accounting professionals agree to record irrational values and make it a standard for the industry to accept and rely upon? Should the Financial Accounting Standards Board (FASB) be charged with fraud instead of the Reserve Management Co.?

  Generally, there are four distinct values, all measured in monetary terms: historical cost, current market value, net realizable value, or present value of future cash flows. For liabilities, the net realizable value may be the settlement amount.

  The definition of fair value considers the concepts relating to assets and liabilities in FASB Concept No. 6, Elements of Financial Statements, in the context of market participants. A fair value measurement reflects current market participant assumptions about the future inflows associated with an asset (future economic benefits) and the future outflows associated with a liability (future sacrifices of economic benefits). I cannot resist but use another quote by John Keynes: “The long run is a misleading guide to current affairs. In the long run we are all dead.”

  Let’s challenge historical cost value and estimated value. The reason why we didn’t see many bad loans held to maturity pre-2008 was because there were no “historical” losses over the preceding 3–5 years to justify higher loan loss reserves. In accordance with GAAP, loans held to maturity are not marked to market as publicly traded instruments, but rather estimated for recovery using techniques (e.g. migration analysis) based on historical losses information. This is like driving a car and watching in a rear-view mirror what is going to happen. If you didn’t get into a car accident previously, it doesn’t mean you won’t have one. Some other accounting estimates, including recoverability of certain assets, are also based on historical experience.

  Here is another caveat about estimates. By recording high loan loss reserves in one year (e.g. 2008), a bank will most likely end up with a net loss in its income statement due to the magnitude of losses, following from a drastic change in the economic environment at that time. After time passes and dust settles, the bank can reverse the “excessive” loan loss reserve back to a “normal” level, thus recognizing a surplus in earnings. These estimates do not change the future performance of the loans. Yet, a single change in an estimate immediately results in a change of earnings to date.

  GAAP represents financial statements on accrual basis in increments of months, quarters and years. The “matching concept” prescribes that costs of resources recognized in the income statement should be matched with corresponding revenues reported in income. This principle allows greater evaluation of actual profitability and performance as it correlates, albeit imperfect, expenditure with earned revenue.

  Let’s challenge accrual method. If a buyer of my goods never failed to pay me, I would accrue for the entire amount of profit based on the “rear view” mirror approach. Future payments are expected based on past performance. If I sold 100 units of merchandise and the title passed to the buyer on or prior to December 31, but he pays on net 60 basis (not till March of next year), I would still account for the sale of 100 units in arriving to my accounting profit in the year ending December 31, as required by GAAP. But what if the buyer, after receiving my goods, fails to pay me on agreed terms? I wouldn’t know about this until I publish my earnings release in early January.

  Group of 20 (G20) calls on accounting standard-setters to achieve a single set of high quality, global accounting standards within the context of their independent standard setting process. Such standards should provide users of financial statements with information that is useful in making investment decisions or performing financial analysis – the first objective of financial reporting in FASB Concept No. 1, Objectives of Financial Reporting by Business Enterprises.

  In my opinion, accounting usefulness comes from one thing only – monetary (cash) value. If financial statements are presented in monetary terms (we see a dollar sign next to reported amounts), shouldn’t all amounts be valued on the same terms? There is plenty of uncertainty in money itself by definition, because money is delayed value. Other values, including historical cost, current market (fair) value, net realizable value, or present value of future cash flows, combined with estimates and accruals, are all non-cash values. Money (cash) is the only value that is more or less consistent, while other values, presented based on the market data, valuation techniques and estimates, can be extremely volatile.

  For example, Earnings Before Interest, Tax, Depreciation and Amortization (EBITDA) and Free Cash Flows (FCF), basis for all business valuation techniques, are calculated using cash basis. Businesses are frequently sold or bought using the multiples method in application to revenue, EBITDA or FCF. Assets and liabilities, upon sale of any business, are always evaluated at liquidation / settlement (cash) value. So shouldn’t accounting value be also recorded using monetary (cash) value?

  Variability hurts. GAAP has become extremely complex and requires years of study, training and practice in order to memorize, understand and implement. Besides, GAAP appears to be in continuous “catch-up mode”, attempting to grasp new concepts of an ever-changing business world – sophisticated financial instruments, unpredictability of future events and increased complexity of economic transactions. Cash, on the other hand, is cash. It either exists or does not, and it changes only in volume if it is printed by the central bank. Any basis to record journal entries, other than cash, brings ambiguity to value based on non-cash basis. Future economic benefits, no matter how accurately predicted, are always unknown.

  At present, there is a debate in the accounting profession whether fair value accounting or its main alternative – historical cost – should become a standard. While historical cost approximates cash value more than fair value, neither of them are free from shortcomings due to ambiguity. Fair value appears to be winning, because it is able to “best” reflect the “reality” of current financial and economic conditions, despite the fact that such conditions can change the very next day or the very next hour. Why not simplify and record everything on a cash basis instead? Past performance is not indicative of future results – why fall into a trap of assumptions about future economic benefits, if historical financial statements, presented in accordance with GAAP, already reflect uncertainty and / or systematic risk caused by economic volatility, debt and other “agents” of financial distortion?

  It would be unfair to the accounting profession to leave things at “stalemate”. There is a need to enhance clarity and promote transparency and robustness in maintaining the accuracy of information provided to the users of financial statements. I make some suggestions in Part III how to reinstate financial statements’ transparency, as well as their comprehension and users’ confid
ence thereof.

  Equity and IPO

  It is easier to visualize the public stock market in analogy of a gold mine, with gold threads (money) scattered in unpredictable and inconsistent patterns. Finding a thread is precious, everything else is a nightmare, caused by academia, system, debt, leverage, traders and the overall resulting confusion.

  While I can understand the purpose of public stocks as cash-out and capital raise instruments for business owners, I don’t understand why they were also dubbed value preservation instruments (e.g. 401(k) pension plans). Theoretically, public stocks could be “value” preservation instruments in industrial expansionary economics due to ever-exponential growth of the global economy. However, the post-industrial economy we live in today appears to be using the stock market exclusively for cash-out and capital raise purposes by the owners (wealth transfer mechanism), because the global economy opened doors to significant systematic, competition and volatility risks. Would anyone invest your savings into something that can lose up to 100% of its value?

  A famous quote of John Keynes states: “The market can stay irrational longer than you can stay solvent.” The public stock market is a very risky way of wealth preservation for this exact reason – the underlying enterprise value (EV) may have nothing to do with its market quoted prices and, as such, cannot be converted into cash (money) at desired exit levels.

  Public stocks’ price mechanism works as follows. When a company decides to go public and list some or all of its shares on the exchange, underwriters and analysts price the shares based on the “fundamentals” of a business, using primarily discounted FCF method. This model justifies initial market capitalization above the accounting book value of equity, because the future cash flows, generated by a company, can be measured and brought to Net Present Value (NPV), which is what enterprise value is to the underwriters (plus or minus some adjustments). Book value of equity, on the other hand, is the difference between assets and liabilities of a company, calculated in accordance with GAAP.

  The future cash flows are uncertain and unknown, prone to high expectations of management, shareholders and underwriters. In other words, there’s a bias – underwriters tend to create demand in order to sell shares they buy at discounted prices prior to IPO. This is somewhat similar to the Central Bank Dilemma section from the Debt chapter.

  Ask yourself the following questions:

  - How much money (cash) value is in the public stock market if all shares are sold at once (because we cannot pay for food with Apple shares)?

  - Why is GAAP book value of equity different from market value or enterprise value?

  - Why doesn’t GAAP allow recording GAAP book equity of public companies at fair or cash value?

  Concluding this chapter, I almost wish public stocks were pegged to their respective companies’ fundamental valuations based on discounted FCF method, or any other method that justifies higher than GAAP book value. This measure would make public companies buy or sell stocks with cash in order to maintain their prices at the fundamental values. Wouldn’t this measure keep things fair and reinstate the value preservation concept of public stocks? This will never happen because there is little or no cash in the public companies’ pockets to back their stock prices at quoted market levels. One will make an argument that it is not right to think of the quoted market prices as cash instruments because the former is a reflection of future economic benefits. I can understand this position, but then why does GAAP allow market float to be recognized as “cash and cash equivalents”?

  Public Stock Market

  P/E ratio means (P)rice per share divided by GAAP (E)arnings per share of a publicly traded company. Price per share is a market price, quoted on a public exchange. Earnings per share (EPS) are GAAP profits divided by number of shares issued and outstanding (basic), as presented in GAAP financial statements.

  Of all the formulas showing the implied interdependence between market prices and GAAP equity, P/E ratio is supposedly the most informative for this purpose, because it calculates the expected return upon stock purchase. Allow me to explain why I believe P/E is nothing but another way to justify value that doesn’t really exist in monetary terms and has nothing to do with the actual or expected return.

  Assume today’s S&P 500 P/E ratio is around 16 – this means that a willing party paid $16 into every $1 of GAAP earnings, generated by the market within the last 12 months. By inverting P/E ratio into E/P ratio, one will derive a profit of 1/16 = 0.0625, or 6.25%, expected to be received by the investor in perpetuity. The logic of people who use perpetuity formula is as follows – if something pays $1 in perpetuity, what is it worth? Perpetuity formula, used in corporate valuation techniques (e.g. terminal value) stands behind the explanation why P/E ratio works in theory – it implies that 6.25% return will be received in perpetuity, i.e. economy will generate this rate of return indefinitely. S&P 500’s price of $16 as a class of assets means that buyers agree to 6.25% profit if they pay $16 today. But is this really the case?

  First off, 6.25% profit is non-cash (as required by GAAP) and there is no assurance the money will be received by the reporting entity for a number of reasons, as was discussed in the Accounting Value chapter.

  Going back to the Accounting Value chapter example of a bank, reversing its loan loss reserves, such bank’s P/E ratio will decrease upon recording of such journal entry. When a bank issues earnings to the public, some investors may think that the bank’s shares are underpriced, based on their target P/E ratio, and rush to buy its shares, thus increasing the bank’s market capitalization. But in reality, performance of the loans and their ultimate recoverability will still be a question and depend on future events.

  Second, stocks are prone to a systematic risk, not associated with the performance of a company itself:

  - If more money is invested into S&P 500 as an asset class, then less return will be expected (P/E ratio will increase), because in this case the performance of the underlying companies will have nothing to do with the investment decision to buy the index.

  - If S&P 500 companies are performing better, their EPS will increase, but it does not mean that P/E ratio will increase as well. This is because if no one buys or sells shares after the performance results are announced, price per share won’t change.

  Price per publicly traded shares can be changed only by the buyers and the sellers, who make investment decisions based on hypothesis of a future growth (future economic benefits), and it doesn’t necessarily have to reflect the underlying performance of the companies. Such scenario usually happens during a financial crisis or a recession, when the stock market first goes down and then up again. This is called a systematic risk.

  Systematic risk is reflected with Beta – a special ratio, showing how price per share changes if the market index (all companies combined) changes. Most of the public stocks center around a Beta of 1, which means there is a 1:1 ratio.

  Unfortunately, there is no such thing as Beta for the overall stock market, that would allow us to see how it changes if the economics change. Had such a Beta existed, we would have observed that change in major market indexes (i.e. DOW, NASDAQ, S&P) is highly correlated with overall economic expectations. This is because the major market indexes are a function of not only performance of specific public companies, but also of the speculative behavior of the market, and how much cash and leverage is available to trade them. I am not aware of a tool that allows quantification of expectations.

  In the real estate investment world, E/P ratio is represented by Cap(italization) Rate, where E is an adjusted annual rent and P is a price of real estate. The general rule of thumb is that when prices are attractive, Cap Rate is above 5%, but when the market is over-heated (e.g. with debt from the banks), Cap Rate is less than 5%. This rule of thumb is a good indicator of where the economy is, but don’t bet your life on it – it may trick you and “stay irrational longer than you can stay solvent”.

  In conclusion, GAAP uses historical informat
ion, fair value, accruals and estimates to calculate earnings and book equity; corporate valuation techniques use fundamental analysis based on expected revenue, EBITDA and FCF to calculate enterprise value (EV); and the stock market uses profit motive to make money using cash, debt, margins and high frequency trading engines, all contributing to a price per share as of the reporting date, resulting in market capitalization of a company, index and ultimately overall market sentiment. While there is potentially some interdependence between these three “forces”, stating that there is causality between them would definitely be a stretch.

  Government and Taxes

  Think of a government as a service or a corporate entity, contributing to justice, safety, protection and general well-being of its citizens. Taxes, collected by the government, represent its remuneration for performing these services. If the government doesn’t cope with its immediate duties, people pay for them out of their own pockets. Since taxes are not a voluntary form of payment, people hold their governments accountable for spending of tax revenue.

  People agree to pay taxes because they can get something in return, i.e. education for their children, medical services for retired citizens, infrastructure and judicial system, because it ensures living in a civilized world. Some governments, which provide a lot of benefits to their citizens, impose large taxes on economic participants. Countries that want to provide more benefits to their citizens should warn them that more taxes are coming, and vice versa.

  The more people are busy and, accordingly, get paid, the more taxes the government collects. This is the way the income tax system is setup in the first place. Individual income tax and social insurance taxes account for the majority of the total tax revenue of the U.S. Government[7].