It has been stated that monetary calculation is one of the great achievements of the human mind and that double entry bookkeeping is what differentiates the system of free enterprise from one of command and control. It is true that without the elegant superimposition that accounting has on the daily activities of the firm, economic relations between actors in the general economy wouldn’t be possible.
However, there is always a word of caution, especially when accounting standards are concerned. Since there are more than one standard, the businessman-entrepreneur is faced with a distinct possibility of obfuscating his internal documents in favor of modern balance sheet “window dressing”.
In this short excerpt, I will only delve into one issue; accounting of long lived tangible assets.
As there are two prominent standard setting bodies in the accounting sphere. One is the FASB and the other the IASB. As things go, one is American, and the other is European. One set of rules are dubbed GAAP and the other IFRS. Both standard setting bodies encourage the use of their accounting rules, but IFRS is predominant in Europe, while US GAAP in America.
As you guessed, both have rules governing the accounting procedures of bookkeeping involving long lived tangible assets. According to both standards, an asset is booked on the balance sheet if there are expected future benefits deriving from this asset (not to confused with revenues which require a constant economic flow of benefits to the firm). If the asset doesn’t fulfill its role as an asset class it should be written down (taken from the balance sheet and placed in the income statement as a loss.
Under US GAAP assets are acquired through the course of regular business activity and they are kept as an ongoing balance sheet item until disposal; abandoned; held for sale etc. They sit on the balance sheet at carrying value and any costs affiliated with bringing the asset to its current state is capitalized. This includes transportation of parts, costs of bringing it into full operational use, interest that is used, if the asset is bought with debt. This is the conservative approach. The other approach is the revaluation approach (only under IFRS) at which the asset isn’t depreciated, but as it is tested for impairment, the asset may be revalued or written down to its fair market value.
What happens when the economy is in a stage of an inflationary credit cycle? If the credit flows into certain asset classes, then, under the revaluation model, the asset will experience monetary gains which bypass the income statement and enter the statement of changes in equity under revaluation surplus. This gain is then reported as part of net income which may be consumed in the normal operational function of the firm.
But, these are fictional gains which are only there because credit demand has pushed up the price of this asset class. This growth in value induces the firm to take on more debt as it is comfortable to do so. In the event of a default, it can pay down its debt with the overly recognized asset. This is of critical importance. Knowledge of balance sheet movements is only one part of the equation.
Understanding the economic consequences of balance sheet changes is a completely different thing, especially in today’s fiat world of frequent expansions and contractions.
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