Economics for Accountants (Part 2)

Why does Financial Accounting exist?

No doubt many a-MAcc student has pondered this question during preparations for final exams.

Well --- lucky you --- I am here to answer all your existential queries. Financial Accounting exists because of the Market for Lemons.

From used cars to GAAP --- isn't that too much of a stretch? Actually not... And here's why.

Instead of thinking about the market for used cars, let's think about the market for firms' shares. Let's consider the case of ABC Corp, which is a growing but privately held firm. ABC's owner is concerned about finding sources of capital that it needs in order to grow. ABC is considering doing an IPO to sell shares to the public.

To tie this back to the Market for Lemons, ABC is the seller (of shares) and the share-buying public is, well, the buyer. As in the Market for Lemons, ABC's management probably knows more about the firm's future prospects than the share-buying public does.

Just to keep things simple and concrete, let's assume that ABC's future profits depend on whether its market position is "Good" or "Really Good." If the market position is "Good", then the NPV of the firm's profits is $100. If the market position is "Really Good" then the NPV of future profits is $200.

Let's further assume that the ABC's management wants to sell a 25% equity stake to outside investors.

Now, if the buyers know the firm's market position, then this sale can work out very easily. ABC sells its 25% stake for $50 if the market position is Really Good. ABC sells it for $25 if the market position is Good.

But what if the buyers don't know what ABC's market position is? And, to complicate things further, what if the seller knows, and the buyer knows the seller knows, and so on? Suppose also that the buyer thinks there's a 50% chance that the firm's market position is Good, and 50% that it's Really Good.

Just like with the Market for Lemons, we can sort out what's likely to happen by asking about what offer the buyer should make.

If the buyer offers $50 for the 25% stake, then half of the time the buyer will be buying a quarter of a Really Good firm, but half of the time the buyer will be buying a quarter of a Good firm. The buyer has paid $50 for shares that are worth

(1/2) * 50 + (1/2) * 25 = 37.50.

Not a good deal for the buyer.

What if, instead, the buyer offers $37.50? Will ABC sell?

If ABC's market position is "Good", then yes, this is a good deal for the seller. But if ABC's market position is "Really Good", then they won't sell. After all, this would mean selling something worth $50 but receiving only $37.50 back. And if ABC only sells when its market position is "Good", then this means the buyer has paid $37.50 for something that's worth only $25.

So again, not a good deal for the buyer.

What if, finally, the buyer offers $25? Will ABC sell?

If ABC's market position is "Good", then ABC is willing to sell. But if ABC's market position is "Really Good", then they won't.

What does all of this mean? As with used cars, we have a market for lemons but not a market for plums. That is, ABC can sell shares when its market position is Good. But it cannot sell shares when its market position is Really Good. Again, the reason is that buyers are afraid of paying a "Really Good" price ($50, in our example above), because it's hard for buyers to determine whether they're buying a "Really Good" company or just a "Good" company.

Now, why do we care about this? We care because the specific market that's failing here is the capital market for plum firms. And it's potentially very bad for society if we starve our very best firms of capital. But that's exactly what's happening.

So I still haven't said how accounting matters in all this. Let's get to that.

What's GAAP? It's a set of rules that firms have to follow when disclosing information about the economic status of the firm. With some exceptions, GAAP doesn't allow firms to selectively disclose things. Firms have to tell current and future shareholders a lot about what's going on with the firm. Armed with this information, buyers might be able to distinguish plums from lemons. And if buyers can tell the difference, then the markets for plums will function --- and our best firms won't go starving for capital.

The key social role of accounting is this: Financial accounting exists to make it harder to sell a Lemon firm for a Plum price. This facilitates trade in capital markets, and allows our best firms to thrive.

Our course, accounting isn't perfect --- just think of Enron for one example of a lemon firm that managed to convince investors it was a plum by manipulating the accounting system. But it's better than nothing.