economic bubble

Fair value accounting

Jesus Huerta de Soto, professor of economics at the Complutense University of Madrid, andprominent promotor of classical liberalism, explains that one of the reasons for the current economic crisis is the abandomnent of prudent accounting practice. What has happened is that assets are no longer valued by their historical value (what did they cost), but by so-called fair value (what could you get for it today) :

To be specific, acceptance of the International Accounting Standards (IAS) and their incorporation into law in different countries (in Spain via the new General Accounting Plan, in effect as of January 1, 2008) have meant the abandonment of the traditional principle of prudence and its replacement by the principle of fair value in the assessment of the value of balance-sheet assets, particularly financial assets.

In this abandonment of the traditional principle of prudence, a highly influential role has been played by stock brokers, analysts, investment banks (fortunately now on their way to extinction), and in general all parties interested in "inflating" book values in order to bring them closer to supposedly more "objective" stock-market values, which in the past rose continually in an economic process of financial euphoria.

In fact, during the years of the "speculative bubble," this process was characterized by a feedback loop: rising stock-market values were immediately entered into the books, and then such accounting entries were sought as justification for further artificial increases in the prices of assets listed on the stock market.

In this wild race to abandon traditional accounting principles and replace them with others more "in line with the times," it became common to evaluate companies based on unorthodox suppositions and purely subjective criteria that in the new standards replace the only truly objective criterion (that of historical cost).

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