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Capital and income financialization: Accounting for the 2008 financial crisis
Accounting Forum 35 (2011) 209–216
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Capital and income financialization: Accounting for the 2008 financial crisis David Hatherly ∗ , Gavin Kretzschmar University of Edinburgh Business School, 29 Buccleuch Place, Edinburgh, EH8 9JS, United Kingdom
a r t i c l e
i n f o
Article history: Received 22 November 2010 Received in revised form 27 May 2011 Accepted 28 June 2011 Keywords: Capital versus income Comprehensive income Financial crisis Financialization
a b s t r a c t Financialization is recognised as a key feature of the 2008 financial crisis. We argue that a lesson is the need for an accounting framework which focuses upon financialization allowing it to be monitored and controlled by stakeholders. We argue that financialization has been permitted through the failure of accounting to distinguish distributable income from capital gains/transfers and to distinguish productive from speculative capital. We introduce an accounting presentation (4S accounting) which effectively makes these distinctions. We use a stylized example to illustrate how it should be applied to the financial reporting of banks. © 2011 Elsevier Ltd. All rights reserved.
1. Introduction A man’s income is the maximum value which he can consume during a week, and still expect to be as well off at the end of the week as he was at the beginning’ (Hicks, 1946, p. 172). The British economist John Hicks provided perhaps the most canonical definition of ‘income’, but admitted it was not precise. Making it precise – in particular, separating income unequivocally from capital – might be ‘chasing a will-o’-the wisp’ said Hicks. Economists, he wrote, ‘shall be well advised to eschew income’. The concept was a ‘bad tool. . .which break[s] in our hands’ (Hicks, 1946: p. 176–177, emphasis in original). Accountants, however, are in no position to duck one of their central classificatory responsibilities. As Dennis Robertson put it, ‘The jails and workhouses of the world are filled with those who gave up as a bad job the admittedly difficult task of distinguishing between capital and income’ (quoted in Kay, 2004) (Hatherly, Leung, & MacKenzie, 2008, p. 131) Financialization is a feature of the period leading to the 2008 financial crisis. We discuss the idea of financialization. From an accounting perspective financialization was evidenced by the balance sheets and profits of banks expanding at a faster rate than GDP (Turner, 2009). We argue that a lesson from the crisis is the need for an accounting framework that focuses upon financialization allowing it to be monitored and controlled by regulators and stakeholders. We argue that financialization has been permitted through the failure of current accounting to distinguish (distributable) income from capital (gains and transfers) and a failure to distinguish what we call production and speculative capital. We introduce an accounting presentation (called 4S accounting) that does effectively make these distinctions and show how it should be applied to the financial reporting of banks. The paper recommends changes in the presentation of banks’ financial performance. The discussion provides insights on the capital versus income debate. If income and capital are to be classified and analysed as they are by accountants, then, we suggest it is incumbent on accountants to clarify the distinction between them.
∗ Corresponding author. Tel.: +44 131 650 2448. E-mail addresses: [email protected], [email protected] (D. Hatherly). 0155-9982/$ – see front matter © 2011 Elsevier Ltd. All rights reserved. doi:10.1016/j.accfor.2011.06.010
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The paper proceeds as follows: the next section discusses financialization and its association with the financial crisis. It is followed by a section on the relationship between financialization and accounting. This section introduces an accounts presentation format which we believe serves to highlight financialization. Section 4 gives a pedagogic example of how this operates. Section 5 discusses the 2008 financial crisis and the relationship between financialization and accounting in the context of banks and other financial institutions. Section 6 covers the implications for policy makers including standard setters. It is followed by Section 7, the conclusion, which links us back to Hick’s famous dictum. 2. Financialization and its association with the crisis Epstein (2005, p. 3) defines financialization broadly as the ‘increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies’. Krippner (2005, p. 174) has written of a ‘pattern of accumulation in which profit making occurs increasingly through financial channels rather than through trade and commodity production’. Accordingly it is a term widely used to describe an economic system that attempts to reduce all value that is exchanged (whether tangible or intangible) either into a financial instrument or a derivative of a financial instrument. Others such as Elliot and Atkinson (2008, pp. 16–17) see financialization in terms of the growth in power and influence of those in the financial sector. It has previously been argued in this journal that financialization is not only a decoupling of financial from productive and tangible asset investment – but that it is also concerned with how gains (and losses) from wealth accumulation (capital) interfere with income flows in national economies (Heilpern, Haslam, & Andersson, 2009). Clarifying the relationship between financialization and accounting, therefore, together with clarification of the accounting principle of capital versus income is, we suggest, not only a matter of stability for the banks and their stakeholders, but a matter of economic principle for our financial system. Financialization is a phenomenon that is not restricted to financial institutions. Researchers (Andersson, Haslam, Lee, Katechos, & Tsitsianis, 2010; Andersson, Haslam, Lee, & Tsitsianis, 2008) have studied financialization in a wide range of companies in an era of ‘shareholder value’ stretching back to the 1980s. The concern is whether pressure for shareholder value has directed strategy. A strategy directed by financialization will attempt to impress the markets and boost equity prices with its contracting (for example through complex derivatives or cost control based upon negotiating strength) and the power of its growth ‘story’ which might be enhanced through the ‘management’ of common performance measures (Andersson et al., 2008). Enron was an extreme example and a harbinger of the 2008 crisis. There is a lively debate as to the extent to which accounting, notably fair value accounting, contributed to financialization of capital and income leading to the 2008 financial crisis – and what the accounting profession’s response should be. To date the debate has largely been in the context of fair value accounting’s role in pro-cyclicality and loan loss provisioning. The Turner review (Turner, 2009) has been an influential critic of fair value accounting – yet the profession remains unmoved. Cairns (2010) has commented that most banks’ financial statements remain dominated by loans and receivables measured by the cost model and that fair value measurement often affects less than 10% of assets – and even less of liabilities. Recently, influential academics (Barth & Landsman, 2010) have vigorously defended fair value and argued that the needs of shareholders in valuing a banking business and the need for financial stability are two different things. We agree, but with the crucial caveat that both economy managers and shareholders need capital and income to be clearly distinguishable. We add to the debate through our suggestion that a central issue is whether current financial accounting processes currently permit both capital and income financialization – without adequately distinguishing between them. The paper that follows, indeed, is not focused upon pro-cyclicality in mark to market valuation as the major economic problem but rather the persistence of capital adequacy problems associated with consumption in excess of production. Accordingly the paper stresses the importance of revenue profits being associated with currently consumable product and of such revenue profits being distinguished from capital gains. This disciplined approach to profit recognition is seen as an important response to the financial indiscipline of the 2000s that led to the 2008 financial crisis notably by legitimizing the financialization of US homeowner ‘equity capital’ into globally tradable fixed income instruments. Mortgage instruments were, in most instances, and most infamously in the case of the so-called class of NINJA [No Income, No Job or Assets] loans packaged into complex credit rated instruments, traded and then financialized into profits, and for the portion retained, into bank capital. This process, in turn, enabled banks to legitimately trade these instruments or even a derivative of these instruments through a process facilitated by accountants (the legitimating role of accountants is well covered by Richardson (1987)), traders and credit rating agencies. This role of accountants and ratings agencies in asset pricing ‘knowledge’ in the context of the crisis is well covered by MacKenzie (2011). To be clear, accounting rules directly participated in the translation of income based mortgages into bank assets through the financialization process. Reducing income related mortgage products to an exchangeable financial instrument made it easier for banks to trade these financial instruments. In essence current accounting and banking rules allow consumption in excess of production, facilitate systemically overpriced asset bubbles – which as we have seen – ultimately require provisioning and the correcting of asset prices. 3. Financialization and accounts presentation/interpretation With financialization the financial sector, notably banking, expands at a faster rate than the non financial, productive sector that financial services are there to support. This as seen by the 2008 crisis is unsustainable. To signal financialization
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a/ 4 S format: comprises 4 funds (assets and equity)/ 4 funds re movements Assets/Equity ESTA CUVI NVP GOV Analysis of Movement Movement Movement Movement movements in ESTA in CUVI in NVP in GOV in fund b/ Current accounting format: comprises 1 fund (assets and equity)/ but 2 funds re movements Assets/Equity: Balance Sheet ESTA plus NVP Movements in balance sheet Profit: ESTA plus CUVI OCI: NVP Fig. 1. A comparison of 4S and current accounting. Part b captures the inability of current accounting frameworks to clearly identify movements within and between assets of a particular class or type (hereinafter referred to as a fund). By contrast the mooted 4S framework (part a) does clarify movements within and between funds.
the accounting framework needs to distinguish the result of productive activity that generates currently consumable product (CPP) from the result of activity that is not directly associated with CCP. We define ‘CCP profit’ as the difference between consumable outputs and matching inputs. Production capital takes its value from the capitalisation of current CCP profit and is therefore rooted in current production. We contrast production capital with speculative capital which takes its value from expected future changes in CCP profits and from the value of legacy promises (contractual commitments) such as pensions and derivatives. We shall see from the pedagogic example given in the next section that CCP (revenue) profit is the yield on production capital invested in both tangible and intangible assets, whilst any other changes in production capital along with changes in speculative capital are in the nature of capital gains or transfers. We associate income financialization with the failure of current accounting to distinguish adequately between CCP profit and capital gains/transfers and capital financialization with the failure to distinguish production and speculative capital. A contribution of the paper is to show how an accounting framework (4S accounting – see below) can clearly signal financialization within both financial and non-financial companies – thus providing a basis for governance and control for both the individual company and for the economy. This signalling process requires that the business is split into four funds (2 in respect of production capital and 2 in respect of speculative capital). The form of presentation is explained in the next section through a pedagogic example of a company whose principal asset is a non-financial contract. The market capitalisation of the company is sliced into four (two in respect of CCP and two which are not) with each slice of equity treated as a separate fund. The 4S statement of comprehensive income analyses changes in each fund including fund transfers and distributions. The question arises as to which fund movements should be treated as revenue profits (income) eligible to justify a distribution. Distribution of gain can take the form of profit related dividend, bonus or taxation depending on the stakeholder who is to benefit. It is suggested that only gains which can be directly associated with the production of currently consumable product or service should be considered for distribution and that other realised gains not directly associated with currently consumable product (CCP) should be invested in productive activities. In a 4S accounting framework the four funds are (1) the equity stake in traditional assets (ESTA – the traditional assets being tangible assets and working capital); (2) the current use value of intangibles (CUVI – the value of intangibles based upon current levels of residual income); (3) the net value of promises (NVP – contractual promises at fair value) and (4) the growth and opportunity value (GOV – as valued by the market i.e. derived from market capitalisation (MC)). ESTA and CUVI are production capital whilst NVP and GOV are speculative capital. It should be noted that 4S is not a model for valuing companies but rather it is a form of accounting presentation that incorporates market capitalisation. In 4S, MC = ESTA + CUVI + NVP + GOV. Introducing market capitalisation is necessary to complete Hick’s No. 1 concept of income in relation to sustaining shareholder wealth. As Bromwich, MacVe, and Sunder (2010, p. 353) report: In general therefore an objective version of Hick’s No 1 ex post concept of the business income of a listed enterprise is more likely to be found in the measure of its shareholder return used in financial economics (dividend plus change in share price), that is, the change in its capital value on the stock market, than in the change in the enterprise’s net assets. The pedagogic example is used to demonstrate how, in 4S, capital financialization is revealed by the growth in speculative capital (NVP plus GOV) being in excess of the growth of productive capital (ESTA plus CUVI). Income financialization may be revealed when the growth in the yield from productive capital is eclipsed by other gains. Investors need to look hard at whether a growth in the non productive assets in excess of growth in the productive assets is believable and justifiable. Other stakeholders need to be concerned as to whether financialization associated with an ‘era of shareholder value’ has prejudiced their interests (Andersson et al., 2010). In the case of the financial sector and banks in particular, financialization is of concern not just to investors and other bank stakeholders but to everyone with a stake in the economy. Fig. 1 highlights the difference between a 4S framework and current accounting practice. In 4S accounting, ESTA, CUVI, NVP and GOV are separate funds each with its own equity matched by assets, and with movements in each fund separately identified. In current accounting there is only one fund of assets/equity represented by the balance sheet. In general this does not include intangibles (CUVI) or growth and opportunity value (GOV), but does include traditional assets at cost (ESTA) and most contractual promises at fair value (NVP). Even this does not cover all situations since intangibles purchased, for
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Fig. 2. Price patterns driving the value of the contract and the value of the company.
example in an acquisition, are included in the balance sheet. In current accounting, movements in the fund that is the balance sheet are split into profit for the year and other comprehensive income (OCI). Profit includes the returns on both tangible assets (ESTA) and intangible assets (CUVI) but these returns are not separately identified. Other comprehensive income covers many, but not all, of the movements in the fair value of contractual promises (NVP). Some of these movements in NVP, notably in respect of derivatives are included in profit. This is a very messy (unclean) state of affairs when it comes to understanding the relationship between accounts and much of modern business given the role of both intangibles and complex contracts in determining current and expected future, performance. In the context of financialization we shall see that it is a state of affairs that does not clearly distinguish either revenue profits from capital gains or production capital from speculative capital. Hatherly (2011) provides further detail on the 4S framework, and how it relates to strategy, stakeholder propositions and accounting reform for non financial companies. Our paper concentrates on the relevance of the 4S framework to financialization, a matter of particular concern to the regulation, accountability and control of banking.
4. A pedagogic example of 4S comprehensive income The following example is adapted from an original UBS footnote illustration (UBS, 2007, pp. 37–38). The selected company is non-financial and has its current business operating through a long term customer contract. The example is designed to illustrate the issues surrounding the relationship between accounting and financialization. In particular the example focuses on the role of NVP, being the value of the contract. We use the example initially to lift out NVP and MC which are subsequently applied along with ESTA and GOV to suggest the relevance of 4S accounting to the banking sector and its regulation. For simplification a discount rate of 5% is used throughout and it is assumed that last year’s business conditions and accounting profit were identical to this year’s. At the end of the accounting year a company has four years left on a contract to supply a commodity of 100 units each year at a price of 10. The spot price of the commodity at the start and finish of the accounting year was 8 and 8.5, respectively. The spot price rise was not anticipated at the beginning of the year. The cost of producing the commodity is 3 per unit. The current accounting profit is 700 (revenue of 1000 less costs of 300). Dividends of 500 are paid leaving 200 cash at the year end. The value of the contract at the beginning of the year is calculated as 200 (the ‘excess’ profits) for each of five years @ a 5% discount rate, giving 865.9. At the end of the year the value of the contract based upon the higher spot price is 150 for four years @ 5% discount rate giving 531.9. Thus the contract loses 334 of value during the year moving from 865.9 to 531.9. At the beginning of the year the expectation is that the spot price will rise to 9 at the end of the contract and then stabilise and this expectation is unchanged at the end of the year even though the spot price has unexpectedly risen to 8.5. The company has 9000 invested in fixed assets and working capital (there are no loans) throughout the year. It remains constant since cash from depreciation is reinvested in fixed assets. Fig. 2 illustrates the price patterns which are driving the value of the contract (termed the NVP or the net value of the (contractual) promise) and the value of the business taken as its market capitalisation (MC). Fig. 3 sets out the movements that combine to give 4S comprehensive income in respect of the example. Fig. 3 explains the flow of value generated during the year by the interaction of the past strategic agreement to share risk and reward with the customer, with the change in market conditions in respect of price.
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Opening balance Yield (5%)
ESTA CUVI
NVP
GOV
MC
9000
1000
865.9
1567
12432.9
450
50
43.3
Fund Transfer
(200)
Change in spot price
177.3
Change in spot price
822.7
78.3
621.6
200
nil
(822.7)
nil
(177.3)
nil
dividends
(450)
Comprehensive income
nil
1000
(334)
(544.4)
9000
2000
531.9
1022.6 12554.5
Closing balance
213
(50)
(500) 121.6
Fig. 3. Statement of comprehensive income.
In Fig. 3 the 9000 equity stake in the traditional assets of fixed assets and working capital (ESTA) is increased during the year by the 5% yield of 450 but this is paid as dividends so that at the end of the year the fund remains at 9000. The current contribution of the intangible assets through sustainable residual income (CUVI) is the capital value of residual income assuming current business conditions persist. The existence of the contract with a price well in excess of the spot price indicates that the accounting profit of 700 is not sustainable beyond the period of the contract. To calculate sustainable profit on which CUVI is calculated the benefit of the contract should be removed from current accounting profit. This benefit is 200 per annum based upon the opening spot price, declining to 150 based upon the closing spot price. Opening CUVI is based upon a sustainable residual income of 50 (700-200-450) which at a multiple of 20 (equivalent to 5%) gives a CUVI of 1000. 450 is the normal profit on the 9000 invested in fixed assets and working capital (ESTA). Similarly closing CUVI is based upon a sustainable residual income of 100 (being 700-150-450) giving a CUVI of 2000, an increase of 1000 during the year. The 5% yield on the opening CUVI is both earned and distributed during the year. The NVP column shows that the 334 loss in the value of the contract can be explained as follows (UBS footnotes, 2007, p. 38): (1) an increase of 43.3 (5% of 865.9) as a result of the passing of the year (the yield from the contract); (2) a reduction of 200 due to the realisation of the benefits of the contract (100*2) during the current year; (3) a fall in the value of the remaining years of the contract (177.3) due to the reducing benefits of the contract following the rise in the spot price (50 for four years @ 5% discount rate). The change in the value of the contract is the result of yield, realisation and change in spot price. The 200 cash from the realisation of benefits is transferred to GOV (a fund transfer: see Fig. 3) and becomes opportunity cash that can facilitate new or further investment. The loss of 177.3 recognises the fall in the value of the contract as a result of the spot price rise but it is offset by the rise in CUVI of 1000 less the fall in GOV of 822.7. Thus in this example the change in the spot price has an overall effect on market capitalisation of zero. This is because the current change in the spot price has not affected the anticipated spot price outside the ‘price protected’ contract period. Current business conditions are unlikely to persist and so growth and opportunity value (GOV) therefore exists based upon expectations of the future. In the example it is assumed that (1) at the beginning of the year the expectation is that the spot price will rise to 9 at the end of the contract and then stabilise and (2) that this expectation is unchanged at the end of the year even though the spot price has unexpectedly risen to 8.50. Opening GOV brings into account the impact of the rise in spot price to 9 in five years time at a value of 2000 (being additional profit of 100 at a multiple of 20) discounted for five years @ 5% to give 1567. At the end of the year GOV shows as a value of 1000 (being additional profit of 50 at a multiple of 20) discounted for four years @ 5% to give 822.6. The decrease in GOV during the year is 1567–822.6 = 744.4 but this is reduced by the fund transfer of 200 to give an overall reduction of 544.4. 4.1. Introducing currently consumable product (CCP) In Fig. 3 the total comprehensive income of 121.6 is the total yield of 621.6 less the dividends paid of 500. The reconciliation of comprehensive income and accounting profit is shown in Fig. 4. It is necessary to consider the value of the company’s production at market value (800) over and above resources consumed (300). The result of 500 is the value of the addition to gross domestic product (GDP) from the year’s activity and represents currently consumable product (line 3 of Fig. 4). The accounting profit of 700 is in fact this production value (CCP) plus a wealth transfer of 200 from the company’s customers as a consequence of the fixed price contract. The yield of 450 on productive tangible assets and 50 on productive intangibles, totalling 500 is also the CCP since the yields on NVP (43.3) and on GOV (78.3) do not provide consumable production. Thus the accounting profit of 700 and the total yield of 621 reconcile through the CCP of 500. In this example the initial yield (450) is on the actual core tangible assets of the company and 50 is generated from core intangibles – but the treatment enables us to isolate and restrict the dividend to the CCP added through the productive
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Fig. 4. Reconciling accounting profit (AP) with comprehension income (CI).
activities with the transfer generated by the fixed price contract and (unrealised) yields on non productive assets being highlighted separately. Dividends have only been paid from yields on productive assets. This conservative dividend policy reflects the fact that the wealth transfer is not sustainable beyond the period of the contract. It is of course possible to pay the realised wealth transfer as a special dividend highlighting its ‘limited period’ character. The customer who is the counterparty to the contract will be showing accounting profit 200 lower than its currently consumable product generated so that the payment of a special dividend should not, from a macro-economic viewpoint, result in distributions in excess of currently consumable product. From a macro-economic viewpoint distributions in excess of CCP can result in economic imbalances that might be associated with general inflation, specific asset price bubbles or balance of payments deficits. Distributions lower than CCP however, can be associated with deflationary conditions. 4.2. The contract as a capital preservation/risk management product1 It is seen from Fig. 3 that neither the change in the spot price nor the realisation of benefits under the contract (the funds transfer) impact upon the market capitalisation, which increases only as a result of the passage of time (yield) on the NVP and GOV. The change in the spot price impacts upon, and generates transfers between, CUVI, NVP and GOV but not upon overall market capitalisation. Thus in the example the contract eliminates risk to the MC in relation to the spot price for the next four years though not in relation to the individual slices of equity. The role of the contract as a risk management product is to reduce uncertainty and to justify therefore a lower required rate of return, resulting in higher capital values. In this way risk management operates upon capital values but does not generate currently consumable product. Risk management is concerned with capital preservation. 5. The 2008 financial crisis In essence, we suggest that the financial crisis arose (at least in part) because consumption was, for the US and UK at least, persistently in excess of domestic production. Global trading imbalances were a key issue (Elliott & Atkinson, 2008; Turner, 2009) though there are many other candidate causal factors. These include: an ideological belief in globalisation irrespective of the mercantilism of trading partners, stakeholder greed and materialist lifestyles, policies of inflation control focused upon the price of consumable product rather than capital values, poor regulation and governance that did not recognise financialization, and innovative financial products which provided the opportunity for highly leveraged growth and a plausible explanation for high profits. Consumption in excess of domestic production was associated with increased debt facilitated by banks eager to leverage their business networks. In the run up to the crisis, global trading imbalances and bank balance sheets both grew at a spectacular rate (Turner, 2009). The financial sector’s increasing profits and balance sheets did not represent a corresponding increase in the wealth of the non financial economy or in GDP. It seems the financial sector organised a substantial wealth transfer in favour of itself. Financialization is the term given to this process through which, arguably, the non financial sector serves the financial sector rather than the other way around (Heilpern et al., 2009). The thesis is that financialization results from bank activities that are neither associated with currently consumable product
1
This interpretation follows from discussions at the Centre for Accounting, Governance and Sustainability, The University of South Australia.
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nor with increased longer term saving. Financialization represents a departure at the macro economic level from the basic rule of double entry that productive assets should be in equilibrium with their funding/financing. The growth of the banks was facilitated by rapidly increasing capital values, especially in property markets and by the ability to create new capital without any corresponding increase in long term saving. To illustrate: when a bank lends money, it flows back to the banking system in the borrower’s current account and again into the recipient’s current account when it is spent by the borrower. If it is spent in China it may be lent back to the UK, firstly to the Treasury and then into the banking system. Thus lending reappears in the banking system as cash available for further lending and, subject to the fractional reserve required by regulation to be retained as cash, there is little requirement for further lending to be constrained by the need to find new savers. There may be a rather limited requirement to find new equity as a consequence of (Basel) regulation but nevertheless expansion is relatively unrestrained. The growing use of derivatives was a further source of unrestrained expansion. The one banking activity which creates currently consumable product is lending to companies that create consumable product. This is the mirror image of borrowing by non financial companies to invest in the leverage of their intangibles. Just as it might be assumed that performing non financial companies will repay loans with new loans so it is assumed that the bank will replace its loans to performing non financial companies with new loans. For the banks such lending is a sustainable business that benefits the economy. However, banks are engaged in a wide range of other lending activities that are not directly associated with the creation of currently consumable product and include lending to individuals for consumption, to private equity, hedge funds and property developers for speculation (capital gains), and to facilitate distributions from capital gains. They are also involved in meeting risk management needs through derivatives and in the securitisation and re-packaging of debt, the latter activity in respect of mortgages being a highly proximate cause of the crisis. Banks will charge fees for their financial support of deals and such fees are effectively a slice of capital. Thus banks transform or help transform capital positions in respect of nature, size, duration, liquidity and risk, but this transformational activity is not directly associated with the creation of ‘currently consumable product’. The banking sector might talk of capital as a product and the transformation of capital as a production process, but it is not the creation of a currently consumable product. It is not the case that innovation in financial services is of itself a bad thing. Innovative propositions can encourage saving and give greater access to capital whilst innovative transformation within and between banks enables such capital to be adapted to the needs of borrowers. However, the bottom line is that both the regulator and, given the regulatory risk, shareholders, must understand how the ‘real’ economy is being served. In a non financialized economy the role of the financial sector is to provide the capital for the non financial sector. The motive for finding innovative ways of transforming or raising capital should be to increase investment in the non financial sector. 6. Implications for policy makers In recent times accounting standards, encouraged by the results of value relevance research which shows the reporting of fair values to impact share prices, international accounting standards have moved to adopt fair value for many financial contracts and for pension assets and obligations. This has been helpful in terms of assessing and justifying the NVP which can then be used within a 4S analysis. However, many movements in the fair value of financial contracts, go directly or indirectly to profit and loss making it difficult to distinguish revenue profits associated with CCP from capital gains. This is a particular issue for banks and other financial services. The charge against the accounting profession is that it has permitted financialization and in this sense it has contributed to the advent of the crisis. Value relevance research does not claim to assist with normative policy making. It is quite possible in the light of the financial crisis that the fair values and share prices used in value relevant research were inflated and not sustainable. Accounting needs to do more than help predict share prices through statistical association. It needs to inform a challenge to the justification for share prices and other stakeholder returns and therefore to help determine share prices and other stakeholder returns in line with fundamentals. This requirement for a non-financialized economy constitutes a major challenge to the accounting profession in relation to the presentation of banks’ financial statements. To meet this challenge we suggest 4S accounting for banks should treat the lending to companies that create currently consumable product (CCP businesses) as being the banks’ sustainable and productive business. ESTA becomes the equity stake in lending to CCP businesses and net interest on such lending is the distributable revenue profit. It is this profit that underpins both ESTA and CUVI. The bank’s portfolio of all other financial contracts are treated as promises and valued at fair value net of precautionary cash (NVP). GOV is a function of both expected changes in the sustainable business (CUVI) and expected future fair value changes in the other financial positions. Impairment charges and loan loss provisions are charged to, and released from, GOV. Net interest on, and fees in connection with, the ‘other’ financial contracts are retained within the NVP ‘fund’. Distributions should not be made from the NVP fund but rather realised gains that are not retained in the NVP fund for precautionary purposes should be invested in loans to CCP businesses. The realised funds are a fund transfer to GOV in anticipation of the new loans and thence to ESTA once the loans are made. As illustrated in the pedagogic example the 4S statement of comprehensive income can demonstrate how value flows or transfers between the four slices of equity. It should therefore reveal the extent to which value is flowing from NVP to the sustainable ‘productive’ business (ESTA and CUVI). Non-financialization requires that value flows in this direction. In effect distributions should be made from the NVP ‘fund’ to expand the lending to CCP business and should not be made directly as distributions in the form of bonuses, taxation or dividends all of which might well be destined to finance consumption that is not currently backed by consumable product. The universal banking model through which a bank for instance supplies
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corporate customers with both lending and derivative products allows the bank to share risk and reward with its corporate customers and to bind its network of customers more closely. However, the challenge is that the universal banking model should be operated in a way that is also non-financializing. Capital gains and fees from the facilitation of capital gain, for example fees from derivatives, should, through appropriate lending, be invested in productive non financial assets. 7. Conclusion Financialization occurs where bank (and other financial sector) balance sheets and profits grow at a faster rate than in the productive sector that financial services are designed to support. Such financialization has been closely identified with persistent trading imbalances and ultimately with financial crisis. The conclusion is that regulation of the financial sector should be focused upon financialization and that 4S accounting can alert regulators, investors and other stakeholders to this issue provided ESTA and CUVI are only based upon profits from lending to support customer activities that directly result in currently consumable product. In the case of banking there may be a case for regulations to restrict or prohibit the making of distributions from NVP or GOV. The motive behind innovative financial instruments should be to raise capital directly or indirectly to invest in the productive sector. Thus realised gains in the NVP fund should not be distributed as dividends, bonuses or taxation, but should be transferred to ESTA or CUVI through investment of the gains in productive tangible or intangible assets. It is the yield on ESTA and CUVI that supports distributions. These arrangements should have the effect of dampening the excesses of the bonus culture but the key impact is that capital gains and transfers are directed to production rather than consumption. Particularly in the light of the Enron case, financialization within individual companies in the non financial sector might also be of concern. Investors and other stakeholders with an interest in the company should examine whether a growth in NVP/GOV in excess of the growth in ESTA/CUVI is justified by the company’s prospects. Accounting therefore needs to inform shareholders and other stakeholders, including regulators and economy managers, of financialization in all companies though in particular banks and other financial sector companies. Hick’s concept of income as the maximum amount that can be consumed in a week whilst leaving capital intact can be applied to each of the four funds that constitute 4S accounting – as well as to market capitalisation. This reveals the gains made within each fund. However, the key question is which of these gains is in the nature of distributable revenue profit and which are capital gains/transfers available for re-investment elsewhere but not for distribution? To answer this question it is necessary to distinguish between the funds using the concept of currently consumable product. Thus the distinction between capital and income is refined into the difference between capital and capital gains on the one hand (for NVP and GOV) and on the other (for ESTA and CUVI) the difference between capital and revenue profit. There is a crucial distinction between capital gains and revenue profit that is not properly recognised in the current accounting framework. Acknowledgements We gratefully acknowledge the comments of the editor, Glen Lehman and of an anonymous referee. References Andersson, T., Haslam, C., Lee, E., Katechos, G., & Tsitsianis, N. (2010). Corporate strategy financialized: Conjuncture, arbitrage and earnings capacity in the S&P 500. Accounting Forum, 34(3–4), 211–221. Andersson, T., Haslam, C., Lee, E., & Tsitsianis, N. (2008). Financialization directing strategy. Accounting Forum, 32(4), 261–275. Barth, M. E., & Landsman, W. R. (2010). How did financial reporting contribute to the financial crisis? European Accounting Review, 19(3), 399–423. Bromwich, M., MacVe, R., & Sunder, S. (2010). Hicksian income in the conceptual framework. Abacus, 46(3), 348–376. Cairns, D. (2010). Accountancy, 145(1399, March), 67. Elliott, L., & Atkinson, D. (2008). The gods that failed: How blind faith in markets cost us our future. London: The Bodley Head. Epstein, G. A. (2005). Financialization and the world economy. Northampton MA: Edward Elgar. Hatherly, D. (2011). Accounting for distributed cognition. Working paper – available from the author. Hatherly, D., Leung, D., & MacKenzie, D. (2008). The finitist accountant. In Swedberg, & Pinch (Eds.), Living in a material world (pp. 131–160). Boston: MIT Press. Heilpern, E., Haslam, C., & Andersson, T. (2009). When it comes to the crunch: What are the drivers of the current banking crisis? Accounting Forum, 33(2), 99–113. Hicks, J. R. (1946). Value and capital: An inquiry into some fundamental principles of economic theory. Oxford: Clarendon. Kay, J. (2004). Ignore the wisdom of accounting at your own risk. Financial Times, (September 7), 21. Krippner, G. R. (2005). The financialization of the American economy. Socio-Economic Review, 3(2), 173–208. MacKenzie, D. (2011). The credit crisis as a problem in the sociology of knowledge. American Journal of Sociology, 116(6), 1778–1841. Richardson, A. J. (1987). Accounting as a legitimating institution. Accounting, Organizations and Society, 12(4), 341–355. Turner, L. A. (Chair) (2009). The Turner review: A regulatory response to the global banking crisis. London: Financial Services Authority. UBS (2007). Financial reporting for investors. In UBS investment research: Valuation and accounting briefing (Stephen Cooper, Analyst). London: UBS (April 16).
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Accounting Forum journal homepage: www.elsevier.com/locate/accfor
Capital and income financialization: Accounting for the 2008 financial crisis David Hatherly ∗ , Gavin Kretzschmar University of Edinburgh Business School, 29 Buccleuch Place, Edinburgh, EH8 9JS, United Kingdom
a r t i c l e
i n f o
Article history: Received 22 November 2010 Received in revised form 27 May 2011 Accepted 28 June 2011 Keywords: Capital versus income Comprehensive income Financial crisis Financialization
a b s t r a c t Financialization is recognised as a key feature of the 2008 financial crisis. We argue that a lesson is the need for an accounting framework which focuses upon financialization allowing it to be monitored and controlled by stakeholders. We argue that financialization has been permitted through the failure of accounting to distinguish distributable income from capital gains/transfers and to distinguish productive from speculative capital. We introduce an accounting presentation (4S accounting) which effectively makes these distinctions. We use a stylized example to illustrate how it should be applied to the financial reporting of banks. © 2011 Elsevier Ltd. All rights reserved.
1. Introduction A man’s income is the maximum value which he can consume during a week, and still expect to be as well off at the end of the week as he was at the beginning’ (Hicks, 1946, p. 172). The British economist John Hicks provided perhaps the most canonical definition of ‘income’, but admitted it was not precise. Making it precise – in particular, separating income unequivocally from capital – might be ‘chasing a will-o’-the wisp’ said Hicks. Economists, he wrote, ‘shall be well advised to eschew income’. The concept was a ‘bad tool. . .which break[s] in our hands’ (Hicks, 1946: p. 176–177, emphasis in original). Accountants, however, are in no position to duck one of their central classificatory responsibilities. As Dennis Robertson put it, ‘The jails and workhouses of the world are filled with those who gave up as a bad job the admittedly difficult task of distinguishing between capital and income’ (quoted in Kay, 2004) (Hatherly, Leung, & MacKenzie, 2008, p. 131) Financialization is a feature of the period leading to the 2008 financial crisis. We discuss the idea of financialization. From an accounting perspective financialization was evidenced by the balance sheets and profits of banks expanding at a faster rate than GDP (Turner, 2009). We argue that a lesson from the crisis is the need for an accounting framework that focuses upon financialization allowing it to be monitored and controlled by regulators and stakeholders. We argue that financialization has been permitted through the failure of current accounting to distinguish (distributable) income from capital (gains and transfers) and a failure to distinguish what we call production and speculative capital. We introduce an accounting presentation (called 4S accounting) that does effectively make these distinctions and show how it should be applied to the financial reporting of banks. The paper recommends changes in the presentation of banks’ financial performance. The discussion provides insights on the capital versus income debate. If income and capital are to be classified and analysed as they are by accountants, then, we suggest it is incumbent on accountants to clarify the distinction between them.
∗ Corresponding author. Tel.: +44 131 650 2448. E-mail addresses: [email protected], [email protected] (D. Hatherly). 0155-9982/$ – see front matter © 2011 Elsevier Ltd. All rights reserved. doi:10.1016/j.accfor.2011.06.010
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The paper proceeds as follows: the next section discusses financialization and its association with the financial crisis. It is followed by a section on the relationship between financialization and accounting. This section introduces an accounts presentation format which we believe serves to highlight financialization. Section 4 gives a pedagogic example of how this operates. Section 5 discusses the 2008 financial crisis and the relationship between financialization and accounting in the context of banks and other financial institutions. Section 6 covers the implications for policy makers including standard setters. It is followed by Section 7, the conclusion, which links us back to Hick’s famous dictum. 2. Financialization and its association with the crisis Epstein (2005, p. 3) defines financialization broadly as the ‘increasing role of financial motives, financial markets, financial actors and financial institutions in the operation of the domestic and international economies’. Krippner (2005, p. 174) has written of a ‘pattern of accumulation in which profit making occurs increasingly through financial channels rather than through trade and commodity production’. Accordingly it is a term widely used to describe an economic system that attempts to reduce all value that is exchanged (whether tangible or intangible) either into a financial instrument or a derivative of a financial instrument. Others such as Elliot and Atkinson (2008, pp. 16–17) see financialization in terms of the growth in power and influence of those in the financial sector. It has previously been argued in this journal that financialization is not only a decoupling of financial from productive and tangible asset investment – but that it is also concerned with how gains (and losses) from wealth accumulation (capital) interfere with income flows in national economies (Heilpern, Haslam, & Andersson, 2009). Clarifying the relationship between financialization and accounting, therefore, together with clarification of the accounting principle of capital versus income is, we suggest, not only a matter of stability for the banks and their stakeholders, but a matter of economic principle for our financial system. Financialization is a phenomenon that is not restricted to financial institutions. Researchers (Andersson, Haslam, Lee, Katechos, & Tsitsianis, 2010; Andersson, Haslam, Lee, & Tsitsianis, 2008) have studied financialization in a wide range of companies in an era of ‘shareholder value’ stretching back to the 1980s. The concern is whether pressure for shareholder value has directed strategy. A strategy directed by financialization will attempt to impress the markets and boost equity prices with its contracting (for example through complex derivatives or cost control based upon negotiating strength) and the power of its growth ‘story’ which might be enhanced through the ‘management’ of common performance measures (Andersson et al., 2008). Enron was an extreme example and a harbinger of the 2008 crisis. There is a lively debate as to the extent to which accounting, notably fair value accounting, contributed to financialization of capital and income leading to the 2008 financial crisis – and what the accounting profession’s response should be. To date the debate has largely been in the context of fair value accounting’s role in pro-cyclicality and loan loss provisioning. The Turner review (Turner, 2009) has been an influential critic of fair value accounting – yet the profession remains unmoved. Cairns (2010) has commented that most banks’ financial statements remain dominated by loans and receivables measured by the cost model and that fair value measurement often affects less than 10% of assets – and even less of liabilities. Recently, influential academics (Barth & Landsman, 2010) have vigorously defended fair value and argued that the needs of shareholders in valuing a banking business and the need for financial stability are two different things. We agree, but with the crucial caveat that both economy managers and shareholders need capital and income to be clearly distinguishable. We add to the debate through our suggestion that a central issue is whether current financial accounting processes currently permit both capital and income financialization – without adequately distinguishing between them. The paper that follows, indeed, is not focused upon pro-cyclicality in mark to market valuation as the major economic problem but rather the persistence of capital adequacy problems associated with consumption in excess of production. Accordingly the paper stresses the importance of revenue profits being associated with currently consumable product and of such revenue profits being distinguished from capital gains. This disciplined approach to profit recognition is seen as an important response to the financial indiscipline of the 2000s that led to the 2008 financial crisis notably by legitimizing the financialization of US homeowner ‘equity capital’ into globally tradable fixed income instruments. Mortgage instruments were, in most instances, and most infamously in the case of the so-called class of NINJA [No Income, No Job or Assets] loans packaged into complex credit rated instruments, traded and then financialized into profits, and for the portion retained, into bank capital. This process, in turn, enabled banks to legitimately trade these instruments or even a derivative of these instruments through a process facilitated by accountants (the legitimating role of accountants is well covered by Richardson (1987)), traders and credit rating agencies. This role of accountants and ratings agencies in asset pricing ‘knowledge’ in the context of the crisis is well covered by MacKenzie (2011). To be clear, accounting rules directly participated in the translation of income based mortgages into bank assets through the financialization process. Reducing income related mortgage products to an exchangeable financial instrument made it easier for banks to trade these financial instruments. In essence current accounting and banking rules allow consumption in excess of production, facilitate systemically overpriced asset bubbles – which as we have seen – ultimately require provisioning and the correcting of asset prices. 3. Financialization and accounts presentation/interpretation With financialization the financial sector, notably banking, expands at a faster rate than the non financial, productive sector that financial services are there to support. This as seen by the 2008 crisis is unsustainable. To signal financialization
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a/ 4 S format: comprises 4 funds (assets and equity)/ 4 funds re movements Assets/Equity ESTA CUVI NVP GOV Analysis of Movement Movement Movement Movement movements in ESTA in CUVI in NVP in GOV in fund b/ Current accounting format: comprises 1 fund (assets and equity)/ but 2 funds re movements Assets/Equity: Balance Sheet ESTA plus NVP Movements in balance sheet Profit: ESTA plus CUVI OCI: NVP Fig. 1. A comparison of 4S and current accounting. Part b captures the inability of current accounting frameworks to clearly identify movements within and between assets of a particular class or type (hereinafter referred to as a fund). By contrast the mooted 4S framework (part a) does clarify movements within and between funds.
the accounting framework needs to distinguish the result of productive activity that generates currently consumable product (CPP) from the result of activity that is not directly associated with CCP. We define ‘CCP profit’ as the difference between consumable outputs and matching inputs. Production capital takes its value from the capitalisation of current CCP profit and is therefore rooted in current production. We contrast production capital with speculative capital which takes its value from expected future changes in CCP profits and from the value of legacy promises (contractual commitments) such as pensions and derivatives. We shall see from the pedagogic example given in the next section that CCP (revenue) profit is the yield on production capital invested in both tangible and intangible assets, whilst any other changes in production capital along with changes in speculative capital are in the nature of capital gains or transfers. We associate income financialization with the failure of current accounting to distinguish adequately between CCP profit and capital gains/transfers and capital financialization with the failure to distinguish production and speculative capital. A contribution of the paper is to show how an accounting framework (4S accounting – see below) can clearly signal financialization within both financial and non-financial companies – thus providing a basis for governance and control for both the individual company and for the economy. This signalling process requires that the business is split into four funds (2 in respect of production capital and 2 in respect of speculative capital). The form of presentation is explained in the next section through a pedagogic example of a company whose principal asset is a non-financial contract. The market capitalisation of the company is sliced into four (two in respect of CCP and two which are not) with each slice of equity treated as a separate fund. The 4S statement of comprehensive income analyses changes in each fund including fund transfers and distributions. The question arises as to which fund movements should be treated as revenue profits (income) eligible to justify a distribution. Distribution of gain can take the form of profit related dividend, bonus or taxation depending on the stakeholder who is to benefit. It is suggested that only gains which can be directly associated with the production of currently consumable product or service should be considered for distribution and that other realised gains not directly associated with currently consumable product (CCP) should be invested in productive activities. In a 4S accounting framework the four funds are (1) the equity stake in traditional assets (ESTA – the traditional assets being tangible assets and working capital); (2) the current use value of intangibles (CUVI – the value of intangibles based upon current levels of residual income); (3) the net value of promises (NVP – contractual promises at fair value) and (4) the growth and opportunity value (GOV – as valued by the market i.e. derived from market capitalisation (MC)). ESTA and CUVI are production capital whilst NVP and GOV are speculative capital. It should be noted that 4S is not a model for valuing companies but rather it is a form of accounting presentation that incorporates market capitalisation. In 4S, MC = ESTA + CUVI + NVP + GOV. Introducing market capitalisation is necessary to complete Hick’s No. 1 concept of income in relation to sustaining shareholder wealth. As Bromwich, MacVe, and Sunder (2010, p. 353) report: In general therefore an objective version of Hick’s No 1 ex post concept of the business income of a listed enterprise is more likely to be found in the measure of its shareholder return used in financial economics (dividend plus change in share price), that is, the change in its capital value on the stock market, than in the change in the enterprise’s net assets. The pedagogic example is used to demonstrate how, in 4S, capital financialization is revealed by the growth in speculative capital (NVP plus GOV) being in excess of the growth of productive capital (ESTA plus CUVI). Income financialization may be revealed when the growth in the yield from productive capital is eclipsed by other gains. Investors need to look hard at whether a growth in the non productive assets in excess of growth in the productive assets is believable and justifiable. Other stakeholders need to be concerned as to whether financialization associated with an ‘era of shareholder value’ has prejudiced their interests (Andersson et al., 2010). In the case of the financial sector and banks in particular, financialization is of concern not just to investors and other bank stakeholders but to everyone with a stake in the economy. Fig. 1 highlights the difference between a 4S framework and current accounting practice. In 4S accounting, ESTA, CUVI, NVP and GOV are separate funds each with its own equity matched by assets, and with movements in each fund separately identified. In current accounting there is only one fund of assets/equity represented by the balance sheet. In general this does not include intangibles (CUVI) or growth and opportunity value (GOV), but does include traditional assets at cost (ESTA) and most contractual promises at fair value (NVP). Even this does not cover all situations since intangibles purchased, for
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Fig. 2. Price patterns driving the value of the contract and the value of the company.
example in an acquisition, are included in the balance sheet. In current accounting, movements in the fund that is the balance sheet are split into profit for the year and other comprehensive income (OCI). Profit includes the returns on both tangible assets (ESTA) and intangible assets (CUVI) but these returns are not separately identified. Other comprehensive income covers many, but not all, of the movements in the fair value of contractual promises (NVP). Some of these movements in NVP, notably in respect of derivatives are included in profit. This is a very messy (unclean) state of affairs when it comes to understanding the relationship between accounts and much of modern business given the role of both intangibles and complex contracts in determining current and expected future, performance. In the context of financialization we shall see that it is a state of affairs that does not clearly distinguish either revenue profits from capital gains or production capital from speculative capital. Hatherly (2011) provides further detail on the 4S framework, and how it relates to strategy, stakeholder propositions and accounting reform for non financial companies. Our paper concentrates on the relevance of the 4S framework to financialization, a matter of particular concern to the regulation, accountability and control of banking.
4. A pedagogic example of 4S comprehensive income The following example is adapted from an original UBS footnote illustration (UBS, 2007, pp. 37–38). The selected company is non-financial and has its current business operating through a long term customer contract. The example is designed to illustrate the issues surrounding the relationship between accounting and financialization. In particular the example focuses on the role of NVP, being the value of the contract. We use the example initially to lift out NVP and MC which are subsequently applied along with ESTA and GOV to suggest the relevance of 4S accounting to the banking sector and its regulation. For simplification a discount rate of 5% is used throughout and it is assumed that last year’s business conditions and accounting profit were identical to this year’s. At the end of the accounting year a company has four years left on a contract to supply a commodity of 100 units each year at a price of 10. The spot price of the commodity at the start and finish of the accounting year was 8 and 8.5, respectively. The spot price rise was not anticipated at the beginning of the year. The cost of producing the commodity is 3 per unit. The current accounting profit is 700 (revenue of 1000 less costs of 300). Dividends of 500 are paid leaving 200 cash at the year end. The value of the contract at the beginning of the year is calculated as 200 (the ‘excess’ profits) for each of five years @ a 5% discount rate, giving 865.9. At the end of the year the value of the contract based upon the higher spot price is 150 for four years @ 5% discount rate giving 531.9. Thus the contract loses 334 of value during the year moving from 865.9 to 531.9. At the beginning of the year the expectation is that the spot price will rise to 9 at the end of the contract and then stabilise and this expectation is unchanged at the end of the year even though the spot price has unexpectedly risen to 8.5. The company has 9000 invested in fixed assets and working capital (there are no loans) throughout the year. It remains constant since cash from depreciation is reinvested in fixed assets. Fig. 2 illustrates the price patterns which are driving the value of the contract (termed the NVP or the net value of the (contractual) promise) and the value of the business taken as its market capitalisation (MC). Fig. 3 sets out the movements that combine to give 4S comprehensive income in respect of the example. Fig. 3 explains the flow of value generated during the year by the interaction of the past strategic agreement to share risk and reward with the customer, with the change in market conditions in respect of price.
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Opening balance Yield (5%)
ESTA CUVI
NVP
GOV
MC
9000
1000
865.9
1567
12432.9
450
50
43.3
Fund Transfer
(200)
Change in spot price
177.3
Change in spot price
822.7
78.3
621.6
200
nil
(822.7)
nil
(177.3)
nil
dividends
(450)
Comprehensive income
nil
1000
(334)
(544.4)
9000
2000
531.9
1022.6 12554.5
Closing balance
213
(50)
(500) 121.6
Fig. 3. Statement of comprehensive income.
In Fig. 3 the 9000 equity stake in the traditional assets of fixed assets and working capital (ESTA) is increased during the year by the 5% yield of 450 but this is paid as dividends so that at the end of the year the fund remains at 9000. The current contribution of the intangible assets through sustainable residual income (CUVI) is the capital value of residual income assuming current business conditions persist. The existence of the contract with a price well in excess of the spot price indicates that the accounting profit of 700 is not sustainable beyond the period of the contract. To calculate sustainable profit on which CUVI is calculated the benefit of the contract should be removed from current accounting profit. This benefit is 200 per annum based upon the opening spot price, declining to 150 based upon the closing spot price. Opening CUVI is based upon a sustainable residual income of 50 (700-200-450) which at a multiple of 20 (equivalent to 5%) gives a CUVI of 1000. 450 is the normal profit on the 9000 invested in fixed assets and working capital (ESTA). Similarly closing CUVI is based upon a sustainable residual income of 100 (being 700-150-450) giving a CUVI of 2000, an increase of 1000 during the year. The 5% yield on the opening CUVI is both earned and distributed during the year. The NVP column shows that the 334 loss in the value of the contract can be explained as follows (UBS footnotes, 2007, p. 38): (1) an increase of 43.3 (5% of 865.9) as a result of the passing of the year (the yield from the contract); (2) a reduction of 200 due to the realisation of the benefits of the contract (100*2) during the current year; (3) a fall in the value of the remaining years of the contract (177.3) due to the reducing benefits of the contract following the rise in the spot price (50 for four years @ 5% discount rate). The change in the value of the contract is the result of yield, realisation and change in spot price. The 200 cash from the realisation of benefits is transferred to GOV (a fund transfer: see Fig. 3) and becomes opportunity cash that can facilitate new or further investment. The loss of 177.3 recognises the fall in the value of the contract as a result of the spot price rise but it is offset by the rise in CUVI of 1000 less the fall in GOV of 822.7. Thus in this example the change in the spot price has an overall effect on market capitalisation of zero. This is because the current change in the spot price has not affected the anticipated spot price outside the ‘price protected’ contract period. Current business conditions are unlikely to persist and so growth and opportunity value (GOV) therefore exists based upon expectations of the future. In the example it is assumed that (1) at the beginning of the year the expectation is that the spot price will rise to 9 at the end of the contract and then stabilise and (2) that this expectation is unchanged at the end of the year even though the spot price has unexpectedly risen to 8.50. Opening GOV brings into account the impact of the rise in spot price to 9 in five years time at a value of 2000 (being additional profit of 100 at a multiple of 20) discounted for five years @ 5% to give 1567. At the end of the year GOV shows as a value of 1000 (being additional profit of 50 at a multiple of 20) discounted for four years @ 5% to give 822.6. The decrease in GOV during the year is 1567–822.6 = 744.4 but this is reduced by the fund transfer of 200 to give an overall reduction of 544.4. 4.1. Introducing currently consumable product (CCP) In Fig. 3 the total comprehensive income of 121.6 is the total yield of 621.6 less the dividends paid of 500. The reconciliation of comprehensive income and accounting profit is shown in Fig. 4. It is necessary to consider the value of the company’s production at market value (800) over and above resources consumed (300). The result of 500 is the value of the addition to gross domestic product (GDP) from the year’s activity and represents currently consumable product (line 3 of Fig. 4). The accounting profit of 700 is in fact this production value (CCP) plus a wealth transfer of 200 from the company’s customers as a consequence of the fixed price contract. The yield of 450 on productive tangible assets and 50 on productive intangibles, totalling 500 is also the CCP since the yields on NVP (43.3) and on GOV (78.3) do not provide consumable production. Thus the accounting profit of 700 and the total yield of 621 reconcile through the CCP of 500. In this example the initial yield (450) is on the actual core tangible assets of the company and 50 is generated from core intangibles – but the treatment enables us to isolate and restrict the dividend to the CCP added through the productive
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Fig. 4. Reconciling accounting profit (AP) with comprehension income (CI).
activities with the transfer generated by the fixed price contract and (unrealised) yields on non productive assets being highlighted separately. Dividends have only been paid from yields on productive assets. This conservative dividend policy reflects the fact that the wealth transfer is not sustainable beyond the period of the contract. It is of course possible to pay the realised wealth transfer as a special dividend highlighting its ‘limited period’ character. The customer who is the counterparty to the contract will be showing accounting profit 200 lower than its currently consumable product generated so that the payment of a special dividend should not, from a macro-economic viewpoint, result in distributions in excess of currently consumable product. From a macro-economic viewpoint distributions in excess of CCP can result in economic imbalances that might be associated with general inflation, specific asset price bubbles or balance of payments deficits. Distributions lower than CCP however, can be associated with deflationary conditions. 4.2. The contract as a capital preservation/risk management product1 It is seen from Fig. 3 that neither the change in the spot price nor the realisation of benefits under the contract (the funds transfer) impact upon the market capitalisation, which increases only as a result of the passage of time (yield) on the NVP and GOV. The change in the spot price impacts upon, and generates transfers between, CUVI, NVP and GOV but not upon overall market capitalisation. Thus in the example the contract eliminates risk to the MC in relation to the spot price for the next four years though not in relation to the individual slices of equity. The role of the contract as a risk management product is to reduce uncertainty and to justify therefore a lower required rate of return, resulting in higher capital values. In this way risk management operates upon capital values but does not generate currently consumable product. Risk management is concerned with capital preservation. 5. The 2008 financial crisis In essence, we suggest that the financial crisis arose (at least in part) because consumption was, for the US and UK at least, persistently in excess of domestic production. Global trading imbalances were a key issue (Elliott & Atkinson, 2008; Turner, 2009) though there are many other candidate causal factors. These include: an ideological belief in globalisation irrespective of the mercantilism of trading partners, stakeholder greed and materialist lifestyles, policies of inflation control focused upon the price of consumable product rather than capital values, poor regulation and governance that did not recognise financialization, and innovative financial products which provided the opportunity for highly leveraged growth and a plausible explanation for high profits. Consumption in excess of domestic production was associated with increased debt facilitated by banks eager to leverage their business networks. In the run up to the crisis, global trading imbalances and bank balance sheets both grew at a spectacular rate (Turner, 2009). The financial sector’s increasing profits and balance sheets did not represent a corresponding increase in the wealth of the non financial economy or in GDP. It seems the financial sector organised a substantial wealth transfer in favour of itself. Financialization is the term given to this process through which, arguably, the non financial sector serves the financial sector rather than the other way around (Heilpern et al., 2009). The thesis is that financialization results from bank activities that are neither associated with currently consumable product
1
This interpretation follows from discussions at the Centre for Accounting, Governance and Sustainability, The University of South Australia.
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nor with increased longer term saving. Financialization represents a departure at the macro economic level from the basic rule of double entry that productive assets should be in equilibrium with their funding/financing. The growth of the banks was facilitated by rapidly increasing capital values, especially in property markets and by the ability to create new capital without any corresponding increase in long term saving. To illustrate: when a bank lends money, it flows back to the banking system in the borrower’s current account and again into the recipient’s current account when it is spent by the borrower. If it is spent in China it may be lent back to the UK, firstly to the Treasury and then into the banking system. Thus lending reappears in the banking system as cash available for further lending and, subject to the fractional reserve required by regulation to be retained as cash, there is little requirement for further lending to be constrained by the need to find new savers. There may be a rather limited requirement to find new equity as a consequence of (Basel) regulation but nevertheless expansion is relatively unrestrained. The growing use of derivatives was a further source of unrestrained expansion. The one banking activity which creates currently consumable product is lending to companies that create consumable product. This is the mirror image of borrowing by non financial companies to invest in the leverage of their intangibles. Just as it might be assumed that performing non financial companies will repay loans with new loans so it is assumed that the bank will replace its loans to performing non financial companies with new loans. For the banks such lending is a sustainable business that benefits the economy. However, banks are engaged in a wide range of other lending activities that are not directly associated with the creation of currently consumable product and include lending to individuals for consumption, to private equity, hedge funds and property developers for speculation (capital gains), and to facilitate distributions from capital gains. They are also involved in meeting risk management needs through derivatives and in the securitisation and re-packaging of debt, the latter activity in respect of mortgages being a highly proximate cause of the crisis. Banks will charge fees for their financial support of deals and such fees are effectively a slice of capital. Thus banks transform or help transform capital positions in respect of nature, size, duration, liquidity and risk, but this transformational activity is not directly associated with the creation of ‘currently consumable product’. The banking sector might talk of capital as a product and the transformation of capital as a production process, but it is not the creation of a currently consumable product. It is not the case that innovation in financial services is of itself a bad thing. Innovative propositions can encourage saving and give greater access to capital whilst innovative transformation within and between banks enables such capital to be adapted to the needs of borrowers. However, the bottom line is that both the regulator and, given the regulatory risk, shareholders, must understand how the ‘real’ economy is being served. In a non financialized economy the role of the financial sector is to provide the capital for the non financial sector. The motive for finding innovative ways of transforming or raising capital should be to increase investment in the non financial sector. 6. Implications for policy makers In recent times accounting standards, encouraged by the results of value relevance research which shows the reporting of fair values to impact share prices, international accounting standards have moved to adopt fair value for many financial contracts and for pension assets and obligations. This has been helpful in terms of assessing and justifying the NVP which can then be used within a 4S analysis. However, many movements in the fair value of financial contracts, go directly or indirectly to profit and loss making it difficult to distinguish revenue profits associated with CCP from capital gains. This is a particular issue for banks and other financial services. The charge against the accounting profession is that it has permitted financialization and in this sense it has contributed to the advent of the crisis. Value relevance research does not claim to assist with normative policy making. It is quite possible in the light of the financial crisis that the fair values and share prices used in value relevant research were inflated and not sustainable. Accounting needs to do more than help predict share prices through statistical association. It needs to inform a challenge to the justification for share prices and other stakeholder returns and therefore to help determine share prices and other stakeholder returns in line with fundamentals. This requirement for a non-financialized economy constitutes a major challenge to the accounting profession in relation to the presentation of banks’ financial statements. To meet this challenge we suggest 4S accounting for banks should treat the lending to companies that create currently consumable product (CCP businesses) as being the banks’ sustainable and productive business. ESTA becomes the equity stake in lending to CCP businesses and net interest on such lending is the distributable revenue profit. It is this profit that underpins both ESTA and CUVI. The bank’s portfolio of all other financial contracts are treated as promises and valued at fair value net of precautionary cash (NVP). GOV is a function of both expected changes in the sustainable business (CUVI) and expected future fair value changes in the other financial positions. Impairment charges and loan loss provisions are charged to, and released from, GOV. Net interest on, and fees in connection with, the ‘other’ financial contracts are retained within the NVP ‘fund’. Distributions should not be made from the NVP fund but rather realised gains that are not retained in the NVP fund for precautionary purposes should be invested in loans to CCP businesses. The realised funds are a fund transfer to GOV in anticipation of the new loans and thence to ESTA once the loans are made. As illustrated in the pedagogic example the 4S statement of comprehensive income can demonstrate how value flows or transfers between the four slices of equity. It should therefore reveal the extent to which value is flowing from NVP to the sustainable ‘productive’ business (ESTA and CUVI). Non-financialization requires that value flows in this direction. In effect distributions should be made from the NVP ‘fund’ to expand the lending to CCP business and should not be made directly as distributions in the form of bonuses, taxation or dividends all of which might well be destined to finance consumption that is not currently backed by consumable product. The universal banking model through which a bank for instance supplies
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corporate customers with both lending and derivative products allows the bank to share risk and reward with its corporate customers and to bind its network of customers more closely. However, the challenge is that the universal banking model should be operated in a way that is also non-financializing. Capital gains and fees from the facilitation of capital gain, for example fees from derivatives, should, through appropriate lending, be invested in productive non financial assets. 7. Conclusion Financialization occurs where bank (and other financial sector) balance sheets and profits grow at a faster rate than in the productive sector that financial services are designed to support. Such financialization has been closely identified with persistent trading imbalances and ultimately with financial crisis. The conclusion is that regulation of the financial sector should be focused upon financialization and that 4S accounting can alert regulators, investors and other stakeholders to this issue provided ESTA and CUVI are only based upon profits from lending to support customer activities that directly result in currently consumable product. In the case of banking there may be a case for regulations to restrict or prohibit the making of distributions from NVP or GOV. The motive behind innovative financial instruments should be to raise capital directly or indirectly to invest in the productive sector. Thus realised gains in the NVP fund should not be distributed as dividends, bonuses or taxation, but should be transferred to ESTA or CUVI through investment of the gains in productive tangible or intangible assets. It is the yield on ESTA and CUVI that supports distributions. These arrangements should have the effect of dampening the excesses of the bonus culture but the key impact is that capital gains and transfers are directed to production rather than consumption. Particularly in the light of the Enron case, financialization within individual companies in the non financial sector might also be of concern. Investors and other stakeholders with an interest in the company should examine whether a growth in NVP/GOV in excess of the growth in ESTA/CUVI is justified by the company’s prospects. Accounting therefore needs to inform shareholders and other stakeholders, including regulators and economy managers, of financialization in all companies though in particular banks and other financial sector companies. Hick’s concept of income as the maximum amount that can be consumed in a week whilst leaving capital intact can be applied to each of the four funds that constitute 4S accounting – as well as to market capitalisation. This reveals the gains made within each fund. However, the key question is which of these gains is in the nature of distributable revenue profit and which are capital gains/transfers available for re-investment elsewhere but not for distribution? To answer this question it is necessary to distinguish between the funds using the concept of currently consumable product. Thus the distinction between capital and income is refined into the difference between capital and capital gains on the one hand (for NVP and GOV) and on the other (for ESTA and CUVI) the difference between capital and revenue profit. There is a crucial distinction between capital gains and revenue profit that is not properly recognised in the current accounting framework. Acknowledgements We gratefully acknowledge the comments of the editor, Glen Lehman and of an anonymous referee. References Andersson, T., Haslam, C., Lee, E., Katechos, G., & Tsitsianis, N. (2010). 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