There have been large changes in the way in which corporate balance sheets and profit and loss accounts are complied. Whereas 20 or 30 years ago, profits or losses generally reflected the difference between the original book cost of an item and the proceeds from its sale, today asset prices are designed to represent their current value and changes in these values are reflected in profits.
The implications of these changes do not seem to me to have been adequately appreciated, with the result that claims that “corporate balance sheets are in good shape” are probably wrong and, as they are widely promulgated, this is leading to serious misconceptions. The current financial turmoil has so far been largely restricted to the housing and financial markets but, if corporate balance sheets are in much worse shape than is generally recognised, the risks that financial turmoil will spread to the non-financial corporate sector is much greater than generally appreciated.
It has been well remarked that no one’s judgement is better than their information and if, as seems likely, the claims about strong balance sheets have been accepted as information, rather than propaganda, many errors of judgement about lending to the non-financial sector are likely to have been made in the recent past and will probably lead to large losses by banks and other lenders.
It is worth remarking that, over the past 12 months, the views of central banks on the soundness of commercial banks’ balance sheets has moved from a complacent assumption that they were well financed to massive concern that they are in bad shape.
It is common to compare today’s corporate balance sheets with those of, say, 10 or 20 years ago and to conclude that, as the debt ratios shown today seem to compare well with earlier ones, balance sheets have improved. But the assumption that today’s apples can usefully be compared with yesterday’s pears is clearly unsound if the change in accounting has had a major impact and there is strong evidence that it has.
One way of judging the impact of accounting changes is to look at the differences between corporate and national accounting, as there has been no similar marking to market change in the latter. For the UK, the data published by the ONS show that private non-financial companies have high and rapidly rising leverage. Net debt amounted to 20% of the value of assets at replacement cost in 1989 but over 50% at the end of 2006. No such adverse change is revealed in the accounts of companies.
A similar problem appears if aggregate balance sheets are derived from the US national accounts data, as these show that non-financial companies have been paying-out more than 100% of their profits in dividends and buy-backs. Up to 1984, a combination of profits’ retentions and new issues allowed a steady rise in net worth in every quarter. Since 1984, buy-backs have exceeded retentions, so that the net reductions in equity have averaged over 3% p.a. With investment in plant and equipment being $4000 bn. p.a. greater than the allowance for depreciation, the national account data published by the BEA point to rapidly rising leverage. In order for the balance sheet data published by the Federal Reserve to conform to the accounts published by companies, the former are adjusted by the addition of “statistical discrepancies” which amounted in total to over $1 trillion in 2007. (Line 20 of Flow of Funds Accounts (“Z1”) – I have added, I hope correctly, the amount shown for each quarter, as these figures seem to be at actual rather than annual rates.). No such adjustment appears to be made to the UK figures published by the ONS.
It could be argued that the convention upon which national accounts are drawn up should be altered. If the Efficient Market Hypothesis is correct, then the stock market provides a perfect guide to the value of corporate assets and the current convention is misleading. This approach, however, produces results which would generally be seen as absurd. Valuing assets at their stock market value would have frequently produced swings in GDP over one year of 20% plus and minus, with total corporate profits often being heavily negative.
I am not arguing that accountants should ignore the current value of assets when producing individual company accounts. Even if the results are ephemeral in aggregate, they may provide a much better guide to the relative positions of companies, comparing one with another. But we should recognise that the aggregate profits and balance sheets they publish will give a misleading impression if compared with similar data from earlier years.
In terms of the national accounts, however, I think that the ONS approach should be preferred to that of the Fed, or at least the Fed should also produce aggregate corporate accounts which depend on the national flow accounts and are not adjusted to conform with the stock (balance sheet) accounts published by companies.
One way of showing that the current presentation is dangerously misleading is to compare the debt ratios shown in the B.102 Table with the ratio of debt to output, which can be derived from the NIPA Table 1.14. According to Table B.102, the domestic net debt of the US non-financial corporate sector has fallen from 41% of domestic net worth in 2002 to 34% today. Measured in terms of debt to output, however, the current ratios are now above their 2002 levels (80% net and 100% gross).
Original work published as Report No. 295 “Are Corporate Balance Sheets In Good Shape?” 21st August, 2007. Followed by article in the Financial Times, published 30th August, 2007 under the heading ‘Why balance sheets are not in good shape’.