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Lies, Damn Lies, And Accounting

They call it the Doctrine of Unintended Consequences . . . an action taken to improve a perceived problem, but which, when implemented, creates a problem as bad or worse than the original difficulty.

A perfect example of this doctrine at work can help to shed light on the current U.S. financial crisis. It involves a little-understood and badly under-reported accounting rule that was put in place in the wake of the Enron Corporation scandal of 2001. Enron, the Houston, Texas, energy giant collapsed like a house of cards when it was revealed that the company had used a questionable accounting scheme to grossly inflate the asset value of its holdings. The collapse left Enron's huge workforce unemployed, numerous members of its senior management charged with felonies, and countless stockholders bereft of their life's savings. The scandal also brought down the venerable Arthur Anderson accounting firm, which was deamed complicit in the scandal by failing to live up to its audit responsibility of protecting stockholders and the public from the devastating financial fiasco.

In the wake of Enron, the Federal Securities and Exchange Commission sought to make the asset value of securities more transparent to stockholders by tightening “Mark-to-Market” accounting standards so that balance sheet assets reflect their current market rather than the price at which these assets were purchased. Clearly the SEC's motive was well-intentioned.

However, in the opinion of numerous economists, the adjustment of these rules is directly related to the current crisis that sent Secretary of the Treasury Henry Paulson with his hat in hand to the Congress in search of what the media and others have dubbed as a Wall Sreet “bailout," designed to remedy the financial chaos that began when real estate markets faltered, followed by failures and/or mergers of major lending institutions. Faced with “restating” the balance sheet value of their mortgage-backed securities at the close of the 3rd fiscal quarter on September 30, firms holding significant shares of these “toxic” securities, saw their ability to borrow money dry up overnight because their asset value was now considered unknown. With the Stock Market in free fall and sources of credit becoming non-existent, the entire economy was said by Paulson, as well as an impressive variety of economic personages, was on the verge of collapse.

Is it possible that such a well-intentioned, yet little-understood, accounting rule alone could be responsible for as much as 70% of the grotesque financial crisis that had delivered the U.S. financial system to such a state of calamity? That's what a host of well-respected free-market economists believe.

Here’s an example of how the Mark-to-Market rules could throw a business into chaos. Suppose that you borrow money to purchase a sizable inventory of products at a set price, and you plan to sell these products at a profit over the next few years. But what if your ability to sell them is governed by an accounting rule that says that if you have one bad sale, you must then mark down the price of the rest of your inventory to match that bad sale . . . say two or three times below what you paid for it. Obviously you would have a liquidity problem, especially if your lender decided to call in your loan. Your products might still be sold at a profitable markup, but your are helpless to do so because of you must “mark” it to the “market” value of your most recent sale rather than keep it at it's purchased value because you plan to hold it until such time as the current downturn is over.

If not the entire reason for the September 2008 meltdown, the arguments posed that the Mark-to-Market rule is at least the proximate cause are fairly persuasive. They suggest that the chairman of the SEC could act to ease the rule so that a $700 billion rescue bill would not be needed . . . or at least not at that high a level of bailout. If you want to read more about the argument behind this point of view,
click here and click here.

To learn more about an opposing point of view that argues for keeping the Mark-to-Marketing rule in place,
click here.

My concern about the current "rescue" bill that is being cobbled together by Congress is that in its haste to solve this financial crisis, the Doctrine of Unintended Consequences will rear its ugly head at an undetermined future hour. Who knows what type of crisis it might precipitate.

In the meantime, I hope that photographers might take a moment to reflect about what accounting means in their businesses. I find that most photographers will do almost anything to avoid looking at and understanding their numbers.
If we learn anything from the current US fiscal crisis I hope it is this: Numbers have meaning that can illuminate or obscure what you need to know about your financial position. I love the statement that was popularized by Mark Twain: "There are three kinds of lies: lies, damned lies, and statistics." The statement refers to the persuasive power of numbers, the use of statistics to bolster weak arguments, and the tendency of people to reject statistics that do not support their positions. The same can be said for accounting. Because the numbers that constitute business accounting can be arranged in different ways, they, too, can be manipulated or rearranged to achieve a desired result.

Most of financial reports that photographers receive from their accountants are Income/Expense statements generated for the purpose of tax filings,
and they are virtually useless for formulating meaningful business strategies. However, the same numbers can be rearranged into a "Managerial" report (see SuccessWare I/E report computer screen below) that will allow you to understand your financial position on a daily basis, while providing additional information that will help you to manage your business with precision. More and more photographers are mastering this common-sense form of accounting that is far easier to understand than tax accounting. Ultimately this knowledge is the first step toward creating a better lifestyle for photographers. So I'm hopeful that the current economic crisis will have the happy unintended consequence of making photographers more interested in not only what went wrong with the U.S. banking system, but also what's going on with their businesses.