Bussiness News
Deflation Accounting Signals Bleak Future
By
Peter Atwater
Jan 13, 2009 11:45 am
Balance sheets sign of hard times ahead.
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In September 2007, I wrote: "[For financial services firms], the income statement is the past; the balance sheet is the future." Had I thought more about it, I would've said that was now true for every company.
Since I wrote that note, we've seen companies of all kinds writing off assets left and right. In many cases, these corporations try to position asset write-offs as "non-cash." And while technically correct, I would again remind readers that the reason the charges are "non-cash" is that the money (or stock) went out the door long ago. And to suggest that these write-downs aren't important is like suggesting that bank-loan losses (also non-cash charges) don't matter.
Asset write-downs do matter - whether they're banks' loan assets, manufacturers' inventory, media companies' goodwill, or government agencies' deferred tax assets. At their core, outside of cash, balance-sheet assets are a forward-looking promise of cash "value" to be received at some time in the future.
So when assets are written down, a corporation or bank is sending a clear message that the future -- particularly future cash flow -- isn't as bright as it once was.
Recently, this thought has had me rethinking the reason the "future" on corporate balance sheets was so rosy - how it was that balance sheets could balloon with more and more forward-looking assets? Obviously a lot of the balance-sheet growth reflected a willingness on the part of manufacturers of all kinds to accept installment notes in lieu of cash - but there's also been a staggering amount of growth in goodwill, intangibles and a whole host of "other assets." Why?
While I won't bore you with the twists and turns of my thinking, where I ended up was simply, at all places, inflation. That, thanks to the basic, historic, economic notion that prices only go up over time, asset values have a floor. And therefore, because of our "inflation bias," we should be willing to recognize more and more of these "promises" on corporation and bank-balance sheets.
But if our inflation bias is truly what has supported the floor for all of our forward-looking assets -- again, everything on the left side of the balance sheet, less cash -- then what happens when deflation hits? As we've seen with Bear Stearns, Time Warner (TWX), General Motors (GM), Fannie Mae (FNM) and Freddie Mac (FRE), already deflation is like a trap door to floor on asset values: The hoped-for promise of cash in the future is suddenly worth substantially less than the reality of cash today.
I don't know where our current deflationary cycle ultimately takes us, but I hope that this helps to better explain how balance sheets reporting hundreds of billions of dollars in assets one day, can show 0 the next. And, more importantly, why -- during periods of deflation -- all balance-sheet assets (other than cash) are of questionable value.
Ultimately, I wonder whether, like the rating agencies, our accounting firms will become yet another scapegoat for our current crisis: That they too, should've recognized the "inflation bias" inherent in balance sheets and some how prevented it from happening; that maybe "cash accounting" should've been used, particularly in a world filled with derivatives and off-balance-sheet vehicles.
But to end where I began: "Earnings are the past; the balance sheet is the future." And with deflation, that future isn't very bright.
Since I wrote that note, we've seen companies of all kinds writing off assets left and right. In many cases, these corporations try to position asset write-offs as "non-cash." And while technically correct, I would again remind readers that the reason the charges are "non-cash" is that the money (or stock) went out the door long ago. And to suggest that these write-downs aren't important is like suggesting that bank-loan losses (also non-cash charges) don't matter.
Asset write-downs do matter - whether they're banks' loan assets, manufacturers' inventory, media companies' goodwill, or government agencies' deferred tax assets. At their core, outside of cash, balance-sheet assets are a forward-looking promise of cash "value" to be received at some time in the future.
So when assets are written down, a corporation or bank is sending a clear message that the future -- particularly future cash flow -- isn't as bright as it once was.
Recently, this thought has had me rethinking the reason the "future" on corporate balance sheets was so rosy - how it was that balance sheets could balloon with more and more forward-looking assets? Obviously a lot of the balance-sheet growth reflected a willingness on the part of manufacturers of all kinds to accept installment notes in lieu of cash - but there's also been a staggering amount of growth in goodwill, intangibles and a whole host of "other assets." Why?
While I won't bore you with the twists and turns of my thinking, where I ended up was simply, at all places, inflation. That, thanks to the basic, historic, economic notion that prices only go up over time, asset values have a floor. And therefore, because of our "inflation bias," we should be willing to recognize more and more of these "promises" on corporation and bank-balance sheets.
But if our inflation bias is truly what has supported the floor for all of our forward-looking assets -- again, everything on the left side of the balance sheet, less cash -- then what happens when deflation hits? As we've seen with Bear Stearns, Time Warner (TWX), General Motors (GM), Fannie Mae (FNM) and Freddie Mac (FRE), already deflation is like a trap door to floor on asset values: The hoped-for promise of cash in the future is suddenly worth substantially less than the reality of cash today.
I don't know where our current deflationary cycle ultimately takes us, but I hope that this helps to better explain how balance sheets reporting hundreds of billions of dollars in assets one day, can show 0 the next. And, more importantly, why -- during periods of deflation -- all balance-sheet assets (other than cash) are of questionable value.
Ultimately, I wonder whether, like the rating agencies, our accounting firms will become yet another scapegoat for our current crisis: That they too, should've recognized the "inflation bias" inherent in balance sheets and some how prevented it from happening; that maybe "cash accounting" should've been used, particularly in a world filled with derivatives and off-balance-sheet vehicles.
But to end where I began: "Earnings are the past; the balance sheet is the future." And with deflation, that future isn't very bright.
Position in SPS, SPY options.
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