Businesses Must Reclaim Prudent Accounting Principles

by Karthik Ramanna - June 12, 2020

Beyond its human toll, Covid-19 has wrought upon us a daunting economic toll. In a matter of just two weeks in mid-March 2020, entire industries and sectors were brought to an abrupt halt. In the UK, for instance, car manufacturing fell from more than 70,000 cars in April 2019 to just 197 cars in April 2020; for further contrast, the UK made more than 120,000 units during February 2020.

To survive a crisis like this, a business must be both efficient and resilient. Prudent accounting - the common-sense accounting concept that there should be a higher threshold to recognizing anticipated gains relative to recognizing anticipated losses - had for generations helped businesses balance these two pulls. In turn, businesses were better prepared for an unpredictable blow. Then, at about the turn of the 21st century, accounting rulemakers did away with prudence. We are living the consequence today: The economy is teeming with crappy balance-sheets that necessitate gargantuan bailouts when crises hit.

Now, concerned about anemic bank lending to industrial companies, regulators have further curtailed prudence. The Fed recently eased a key accounting restriction that encouraged more responsible lending and ensured that banks had a robust cushion against crisis-induced losses. In the UK, the central bank is so alarmed by weak lending to corporations that it is urging financial institutions not to book big charges on potentially souring loans. These practices constitute the opposite of prudence.

A financial crisis like our current one was not unimaginable. It has only been slightly more than a decade since the world last experienced a sudden shock to global industrial solvency, and the idea that such a shock could come from disease was made very real by the near-miss Ebola and Zika outbreaks of 2014 and 2016. So the real question is how do we avoid finding ourselves here again when we face the next major economic shock? One answer is to bring “prudence” back to corporate accounting.

How Prudence Balances Resiliency and Efficiency

Resilience is the ability to withstand and recover from negative shocks. Resilience is slack - the capacity to absorb failure and continue onward. You are not resilient if you’ve continued to hold on to that loss-making division instead of shutting it down. You are also not resilient if you have underused debt in growing your business, because it likely means you have not diversified to a level where you can now afford a few failures.

Efficiency simply means greater output and lesser waste for a given quantity of input. Efficient organizations are asset light and more leveraged, relative to peers - features that seemingly make them less resilient. They appear to have fewer reserves to draw on when the rains fail. But being asset light really means you are carrying less excess baggage when you need to move quickly; it does not mean that you have shed yourself of the essential baggage. Companies, like would-be dieters, often get this wrong in their quest to being lean. Similarly, being more leveraged than your peers means you can do more with less capital, which can be hugely advantageous when capital is scarce, as during a crisis. The key is to assume only as much leverage as you need to operate at efficient scale and scope, and not to assume leverage to pay out dividends or bonuses, as several banks did before the last financial crisis.

Prudent accounting balances the forces that drive a business to be efficient and resilient by helping a company stay asset light and forcing it to write off dud projects as their losses become apparent, even in otherwise good times. Such a company is thus less likely to throw good money after bad, lowering waste in the company and in the economy. And, when bad times hit, the company is less prone to be carrying unwanted costs, a huge relief for everyone, including the taxpayer.

Likewise, when a prudent company raises debt, it does so despite the downward bias in its accounts - so that debt is safer, in that it sits on a more conservative cushion. This makes the company and its creditor less likely to fail when a crisis hits.

And finally, by being prudent in good times, the company has recognized losses earlier, and attenuated the scale of its dividend and bonus payouts. This means there’s more of buffer in retained capital to weather it through a crisis.

Getting Back to Prudence

Prudence is both a regulatory principle and a managerial state of mind. To bring back prudence into accounting thus requires two layers of action. First, the U.S. Securities & Exchange Commission (and its equivalents worldwide) should mandate that any new accounting standards - and indeed any accounting standards issued since about 2000 - meet the prudence test. Put differently those standards should require objective evidence before companies can book gains (or avoid losses) on the basis of expected future profits.

Second, boards and auditors should exercise greater skepticism when approving CEO and CFO judgments on highly discretionary items such as capitalizing intangibles and avoiding goodwill charge-offs. In anticipating such pushback, senior management will then impose their own higher standards in making these decisions, resulting in higher quality balance-sheets.

Prudence in accounting practice has been around since at least the 1400s, and by the late 19th century and the advent of modern capitalism, it was already a well-developed and widely regarded principle. We foolishly abandoned this history quite recently, but two major financial crises and trillions in bailouts later, we must reclaim it.

Karthik Ramanna is professor of business and public policy at Oxford University’s Blavatnik School of Government.