Monthly Archives: July 2006

So, we start trying to decide whether accountings that the average investor can understand are feasible. The first question is whether the average investor can understand business in the “new economy.” To oversimplify, it seems to me useful to divide the new economy into 2 pieces: First, there is the world of post-modern finance: derivatives and their progeny. Second, is the world of high-tech.

When I think of derivatives, I always think of the old Eddie Murphy movie, Trading Places. Ralph Bellamy and Don Ameche are trying to explain the futures markets (the first public derivatives market) to the street person played by Eddie Murphy. Insightfully, Eddie noted something like “you guys are bookies.” Black and Scholes (after whom the first model for valuing derivatives is named) could not have put it better. Derivatives are just fancy bets on the value of something, with little or no investment in the item gambled on. Pricing the gamble is hard. Understanding the gamble is easy.

High tech below.

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The question today is what to do in light of the fact that the accountings currently provided to individual investors are impenetrable. Most obviously, one would like penetrable accountings. Unfortunately, that is easier said than done. The question is how hard we should try to come up with penetrable accountings. Today, I argue that we should try real hard, as the alternatives are not happy.

We could no nothing and let things go on. After all, if it made economic sense to have better accounting, market forces would make companies have better accountings. Well, no. Market forces likely encourage a company competing with others for capital to provide comparable accountings. Market forces do not necessarily protect entire markets or investors as a class. The US saving rate is frighteningly low. Bad accountings, and the resulting distrust of the markets, particularly the stock markets, may be part of the problem.

One still might not care. Let people do stupid things. I’ll put my money in the bank or a mutual fund. But, if a rising tide raises all ships, even a smart loner could benefit from better markets.

Old Europe down under.

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Betty the Crow News called my attention to a great little piece about Enron in the the San Francisco Chronicle that expresses my views about Enron and my point the numbers matter far better than I could On Facing Facts

Yesterday, I wrote about the process by which corporate financial information is processed and presented to investors. It was my plan to write about how that process effects the quality of the product. But, it seems more fun to cut to the chase and think about, in light of this process, what financial information should be given investors. (Perhaps later we can chat about the audit process.) The goal here is to evaluate whether it is troubling that most investors could not understand Enron’s financial statements, which is where this discussion began.

Should investors understand the basic financial attributes of a company they invest in? Few car buyers understand modern automotive engineering; yet nobody thinks that this means that there is something wrong with the automotive markets. (Hey, I’m from Detroit: Cars are an analogy to everything.) Individuals can get expert analysis from places like Consumer Reports and JD Power. Reputation and brands provide useful non-technical information about a car. Experience over time drives (pun intended) bad cars out of the market. And so on.

But, cars are not corporate stock. Click for the analysis underlying this surprising conclusion.

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Yesterday, I argued that raw cash flow numbers alone are not enough information for an investor to understand a company. The accounting industry always understood this. In fact, cash flow statements were not required until 1987!

What about giving an investor complete access to all (non-confidential) financial information, which the investor then can massage as she sees fit? While this would have seemed impossible in 1933, presumably it could be done today. The SEC is trying to get companies to do financial filings in a format called XBRL, which permits the reader to analyze underlying data. More sub fold.

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