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The writer, an FT contributing editor, is chief executive of the Royal Society of Arts and former chief economist at the Bank of England
Accounting rules rarely arouse excitement — even among accountants. This neglect is misplaced. Accounting is the DNA of capitalism. And accounting rules have been pivotal in shaping the fortunes of companies and economies over many centuries, for good and ill.
Historically, accounting systems have been used to explain the rise and fall of nations ever since their emergence in ancient Mesopotamia. Goethe called double-entry bookkeeping one of the finest inventions of the human mind. Political philosophers such as Adam Smith and Max Weber assigned accounting systems a central role in explaining the flourishing of modern corporations and economies.
That is not to say these rules have been uncontroversial. A particular bone of contention has been the accounting valuation of assets, whether at market prices (“fair value”) or historic cost.
The US, for example, shifted towards fair values in the early years of the 20th century. But in 1938, in the teeth of the Depression, President Roosevelt moved back to historic cost accounting due to concerns that fair values were causing fire sales of assets and aggravating economic distress. Similar pivots away from fair value occurred in the 1990s and in the wake of the global financial crisis.
At the start of the 21st century, countries in the EU changed accounting rules for listed companies to International Financial Reporting Standards (IFRS). These had a much stronger basis in fair value. The 2005 reforms had the same aims as those in the US a century earlier — improved corporate transparency, a lower cost of capital and higher levels of business investment.
Taken at face value, however, results have not been consistent with these objectives. Business investment by EU companies, relative to sales, has halved since 2005. For some countries, including the UK, business investment has been materially lower, relative to GDP, than in the US where Generally Accepted Accounting Principles (GAAP) maintained a historic cost focus.
The public policy question to ask is whether these patterns are causal. There are good theoretical grounds for thinking they might be if fair value accounting rules encourage managers to take short-term decisions. In particular, they may cause companies to prioritise shareholder payouts, inflated by asset price inflation, over reinvesting. If so, this accounting-induced short-termism could harm business investment and economic growth over the medium term.
A recent econometric analysis of more than 5,000 listed EU companies over the past 30 years by Vera Palea, Alessandro Migliavacca and myself supports this. After controlling for other factors, the switch to IFRS accounting rules is found to have damped business investment by between a third and a quarter, given available opportunities. This has affected every sector.
The primary driver of this investment drag has been the rise in payouts (dividends and buybacks) to shareholders. Since 2005, payouts have doubled as a ratio of sales among listed EU companies. Prior to the introduction of IFSR, fewer than 10 per cent of EU-listed companies paid out more to shareholders each year than they invested. By 2019, that had risen to around a third.
While the study focuses on non-financial companies, there are good grounds for believing similar effects operate among financial firms such as pension funds. Accounting and regulatory rules (Solvency II) led to pension funds’ liabilities being, in effect, marked-to-market. This contributed to their sharp fall in willingness to invest in companies for the long term. During this century, UK pension fund investment in UK-listed companies has fallen from over 50 per cent to around 4 per cent of their assets.
The costs are not only in lower investment and growth. In follow-up analysis, Palea and co-authors estimate that IFRS rules have added to EU carbon emissions by around 15-30 per cent per year, relative to a GAAP benchmark, given their adverse impact on investment in green technologies. Accounting-induced short-termism has been a headwind to green growth.
With growth subdued and progress towards net zero slow, it is an ideal time for Europe to reconsider whether accounting standards support green growth objectives. In the UK, unencumbered by EU Directives but with a larger growth and investment deficit, a new government offers the perfect opportunity for a rethink and overhaul. Today, as in Depression-era America, IFRS may not be among the finest inventions of the human mind.
Read the full article here