Broken Symmetry

What should the FTC and SEC do first to help consumers?

The answer is redesign financial statements. Don't leave it to the FASB, which is like letting the foxes guard the henhouse.

The occasion for this reflection came today as Christine Varney announced a series of workshops aimed at improving the Merger Guidelines. Lots of interesting hints in this speech. I was particularly interested in this topic:

[W]e are interested in your views on the use of more direct evidence that is not strictly based on inferences drawn from increases in market concentration. There are several categories of such evidence worth exploring: (1) evidence of the actual, post-merger competitive effects of consummated mergers, (2) evidence of "natural experiments" obtained by looking across different geographic markets, time periods, customer categories, or similar product markets; (3) evidence of the firms' post-merger plans; (4) evidence of customer views of post-merger competition; (5) historical evidence of actual head-to-head competition between the merging firms; and (6) historical evidence of actual or attempted coordination in the industry. Although the Agencies routinely rely heavily on these kinds of evidence to assess competitive effects, the Guidelines address their relevance only in passing and only secondarily, after the relevant market is defined and concentration in that market is measured. Courts also regularly rely on this type of evidence in assessing competitive effects.28 We are interested in views on whether we should adjust the Guidelines to address explicitly what kinds of direct evidence are pertinent and how they should be weighed.

Is it too much to ask that the FTC and the SEC coordinate on this? Recall that Goldman Sachs CEO Lloyd Blankfein recently suggested reforming the accounting rules to require all exposure to flow through to financial statements. Not only might these kinds of reforms benefit the SEC in enforcing its rules, it would give the FTC a better source of data -- at least for public companies -- on which to base econometric analyses of substitutability, for example. Needless to say, investors and ultimately consumers would benefit from having better information too.

Long time readers of Broken Symmetry may recall earlier posts (here, here, and here, for example) on how financial statement report only snapshots in time and time-averages of sales and costs of sales. These were all that was needed when buying and selling patterns changed only annually, or at fastest quarterly. To handle more rapid changes, you have to increase the sampling rate. What we need is a time-series of balance sheet accounts, or income/cash-flow statements on shorter intervals.

Having better designed financial statements would benefit consumers far more overall than even perfectly clear merger guidelines or perfectly efficient SEC enforcement.

How hard would it be for economists from the FTC to sit down with economists from the SEC and hammer out a set of economic data that should be required from public companies but that isn't in the financial statements now? To make it palatable politically, they could offer to get rid of Sarbanes-Oxley hassles in exchange for more information. Have a time-delay of the release of real-time balance sheet info to deal with the trade secret issues.

Great Suggestions for Financial Reform

From Goldman Sachs CEO (and former lawyer) Lloyd Blankfein:

[A]ll of the exposures of a financial institution should be reflected through the P&L. Consider Structured Investment Vehicles or SIVs and other off-balance sheet vehicles that represented significant sources of funding for financial institutions around the world. Unfortunately, risk models failed to capture the risk inherent in these activities. Post Enron, that is quite amazing. If contingent liabilities and stand-by credit commitments don’t flow through the P&L, how can risk managers and regulators see the risks that a bank is exposed to?

Blankfein's views are balanced and obviously well-informed. We could do worse than to follow the lead of the leader of one of the handful of institutions that came through the crisis smelling like a rose. Goldman Sachs clearly had a better understanding of what they were doing and of how the system as a whole was functioning than did other stakeholders, including government regulators.

Why Inventory Turnover Rates Matter to Managers, Owners, and Investors

From the always illuminating Joe Ponzio:

Everything else being equal, the 10% margin business with one inventory turn is no better or worse than the 2% margin business with five turns a year.

In fact, as Joe explains in the rest of his post, the company doing five turns a year is often in better shape. If you want an analogy, it's like the difference between two cars, both of which can carry you 100 miles on 9 gallons of gasoline, but one of which does so at 5000 rpm the whole way while the other does so at 1000 rpm. Same fuel efficiency, but you'll pick the car with more torque every time. You can accelerate or slow down much quicker with the 5000 rpm machine.

Sometimes inventory turnover rates are reported as part of financial statements, usually in the notes. An inventory turnover rate is a frequency -- i.e., given a unit of inventory the turnover rate is in units # / time. Repeatedly on this blog I have suggested that financial statements should report frequencies for each balance sheet account. Such frequencies are called "turnover rates" when the accounts in question are inventory accounts.

Note that accountants usually order balance sheet accounts from short-term to longer-term liquidity. That's a convention, not a measurement. Wouldn't it be nice to have actual numbers for each account?

How Economics Can Become Scientific

The MIT Technology Review blog today reviews a "paper describ[ing] a survey taken by graduate students at seven top-ranking economics programs" on answers to questions, including the following:

• Is neoclassical economics relevant?
• Do economists agree on fundamental issues?
• Can fiscal policy be an effective stabilizer?
• Should the Fed maintain a constant growth rate of the money supply?

The results are mixed. Not a surprise since even among economists the answers to these questions are mixed! But the title of the post raises a large question, which I'd like to answer using systems theory -- i.e., the theory of how highly integrated social networks self-organize. Systems theory has been a central theme for this blog.

If we understand the question in terms of systems, then we can answer in layers the question, "Is economics a science?" These categories are linked to the three generalized components that make "the system of economics":

1. The domain of rules and procedures that make up economic theory;
2. the field of recognized experts who act as gatekeepers to the domain; and
3. the stream of data in the form of observations or measurements used to falsify the domain.

The high-level answer is that economics is a science if it has active components of domain, field, and data. Economics is not only dismal, but dead if none of these is changing. But so long as each of these three have some time-dependence, the difference between economics and other sciences is a difference in degree, not kind.

But on closer inspection, there are indeed apparent problems with these components for economics that do not exist for other sciences. The biggest problem seems to be that at least until about ten or twenty years ago, there was no stream of data on individual or group behavior that could be used to falsify the domain of neoclassical theory that developed around WWII. In other words, there have been few new experiments or new kinds of data sets since neoclassical theory was developed. The field has become somewhat retrenched as it has labored at refining its theories using the same sets of data over and over again.

There are exceptions, of course. I'm in the middle of reading Vernon Smith's Rationality in Economics, in which he describes the interesting ways that actual behavior deviates from neoclassical predictions in actual experiments and field studies. And Smith is not laboring in obscurity, of course. He won a Nobel for his efforts in this regard. But in general, the "science" of economics seems to have been limited by a lack of data. There simply has not been an experimental or observational mechanism for the field to reach consensus on what hypotheses have been falsified.

In perhaps not-so-humble fashion for a non-economist, I would like to propose that experiments and observations of the average time period between individual acts of consumption or production is exactly the kind of data that economists could use to falsify models of individual or group behavior. The fact that such observations have not been made in the past is no accident, for they were generally too expensive to be collected before the Internet became widely available. (Csikszentmihalyi's Experience Sampling Method is a notable exception.)

Journal entries themselves encode the information that is necessary for managers, investors, and owners of corporations to see the frequency spectrum of activity within a firm that provides a unique signature of the firm's activities. Time-averaged measures of costs are not the only variables important to the health of a corporation. Profit is a function of sales and costs of sales over time.

Economics could become more scientific by statistical observations of individual and group behavior over time.

Huh? Why would the Efficient Market ignore synergies?

More very strange analysis from Fama and French:

Firms often pay a substantial premium to the market price when making acquisitions. Does their willingness to pay a premium suggest the shares of target firms were mispriced?

EFF: The empirical evidence says that all the gains from mergers are eaten up in the premiums paid to acquire firms. On average, the acquiring firm gets nothing. This doesn't necessarily imply that the shares of the acquired firm were mispriced since there can be synergies (real business gains) from mergers.

KRF: Takeover premiums do not imply that the target firms were mispriced. Since we do not expect the market to accurately forecast every acquisition that will create value, we should not be surprised that prices rise when tender offers and mergers are announced.

Either the price is right or it ain't, right? Why would "synergies" matter if not to price?

Firms are subsystems embedded in a larger economic ecosystem. Synergies do matter. Beyond certain thresholds, otherwise linear correlations can go nonlinear, with concomitant consequences for growth or decay. But F&F are equivocating here. If synergies matter, then why wouldn't they be reflected in pre-announcement price? Shouldn't "the efficient market" be able to price in the probability of a merger and its resulting synergies?

As usual, a close look at the temporal dynamics suggests problems with EMH.

What do Music and Quantum Mechanics Have in Common?

Time and frequency are a Fourier pair:

The key to using music to teach modern physics, in my mind, is harmonic analysis. Harmonic analysis is nothing other than Fourier analysis, a tool which is highly valued in physics and engineering. It is not widely known by the non-scientist, yet it is easy to explain in the musical context—when someone looks at a graphic equalizer on their stereo they are looking at a real-time Fourier amplitude analysis of the music that is being played. One can explain how the synthesis of harmonics affects the timbre of musical sound—how the coefficients in a Fourier series can describe different real functions. A very simple example is the comparison between the organ pipe and the piano string. The ‘stopped’ organ pipe has only odd-numbered harmonics and the piano has all harmonics. (Because the ‘stopped’ organ pipe has a pressure node at one end and a pressure antinode at the other, whereas a string has nodes at both ends.) The different symmetry of the boundary conditions accounts for a major aspect of the difference in the timbre of the organ and the piano.

That's from The birth of the blues: how physics underlies music by J.M. Gibson. Via Physics and Physicists

If you're a regular Broken Symmetry reader, then you should know already that it is not only music that can be understood better with Fourier Analysis, but any time-series that can be decomposed into ocillations of different frequency, including cash-flows. The balance sheet is sort of like the graphic equalizer, except that the frequency of the accounts is not rigorously ordered in terms of liquidity. If it were, then the analogy would be complete.

Goldratt, Lean, Flow, and Financial Statements

Over at Evolving Excellence, Bill Waddell writes about how Lean Theory and Eli Goldratt's Theory of Constraints are part and parcel:

That focus on flow is at the very heart of excellent manufacturing - not merely finding tidbits of waste and eliminating it. The final step in the logical thought progression is that the most fertile ground in the effort to accelerate the flow of products across the fixed costs within the value stream is to know what is limitingthe flow - and that is where Eli Goldratt comes in. He said that an hour saved at the bottleneck (constraint) is an hour saved for the system (in lean terms, an hour saved for everything within the value stream). An hour saved anywhere else is a mirage.

Both theories focus on the frequency spectrum of activities within the firm rather than a time-averaged picture of costs. That's why lean is such a pain for cost accounting, which is based on time-averaged measurement of costs.

As mentioned in an earlier post here, what Goldratt calls "throughput" could also be called flow. Both are quantities per unit time.

If balance sheets included frequency-averages (i.e., turnover rates) for each account, would accountants be able to move assets or liabilities on and off the accounts without there being a trace on the financial statements? Right now, an asset moved on and off the balance sheet betwen the period of financial statements may not show up in the income statement or cashflow. These are time-average pictures of income and cash, and by definition an asset moved on and off within the period of time produces no net effect on the time-average.

We have blinded ourselves by excluding information about flow from our financial statements.

Excellent Sentences from Joff Wild at IAM

However, how do you measure value when IP can be so frustratingly intangible - what price that collaborative relationship with a competitor that a piece of IP may enable, for example? One at least partial solution to this conundrum may be to make royalty rates far more transparent. One suggestion was that all licensing deals agreed in the US should be publicly recorded at the USPTO so that people could see the sums involved. This would have to be compulsory as no-one would do it voluntarily.

From the IAM Blog.

Why Accounting Information Should Be Reported in Real Time

The activities of firms are cyclical. Even if a firm has only one customer that places only one order, or multiple orders at apparently random intervals, the activities of the firm that serves that customer will be cyclical in response to the order or orders. The ultimate reason for this is that human biology is cyclical, characterized by (for example) circulatory, circadian, and neurolgical rhythms that can be adjusted only within certain limits.

Managers and accountants keep track of the cycles of activity within firms using a variety of tools, including financial statements. In a nutshell, each set of financial statements gives managers a snapshot (the balance sheet) and a time-inegrated sum (the income or cash-flow statement) of the result of the cycles of activity that occurred during the period of the financial statement.

It almost goes without saying that no manager would try to run her company reading only the financial statements. On a day to day basis, managers look at a host of other measurements in order to understand whether the company is growing or shrinking as a result of the cycle of activities within the firm. Nonetheless, at the end of the day, the key question for every manager is whether each cycle of activity within the firm is increasing profitability (and hence equity) over some time horizon.

Again, it almost goes without saying that investors are interested in the same thing -- i.e., with increasing the profitability (and hence, equity) of the firm. Yet unlike managers, investors now have access only to the financial statements produced by the firm. And financial statements are available now only once per quarter.

It is a mathematical fact that the frequency of measurement must be at least twice the frequency of a signal for the frequency of the signal to be detected accurately. What this means is that even if all relevant accounting information is accurately reported on financial statements investors now have no way of measuring changes in the frequency of cycles within firms that occur faster than twice a year!

Ask any electrical engineer and they will confirm that the shortest cycle you can measure accurately is twice the length of the cycle of sampling. Any cycle shorter than that will be "folded over" into the sample.

Isn't this basic insight important to understanding how we could prevent a recession or depression like this one from spiralling out of control in the future? Maybe if investors could see how things change within firms more often than twice a year they could be more effective at putting the breaks on bad management.

Maybe the SEC should focus on making accounting information available to the public in real time through technology like XML rather than prosecuting managers for misconduct years after the damage has been done.

Bleg for Information about Management Accounting of Changes in Frequency

Any readers have experience or knowledge here?

A time series of journal entries records sales and costs of sales. Later these are summarized into income statement, balance sheet, and cash flows. Lost in these financial statements is the information about how often each unit of sales and costs of sales was earned or incurred, respectively. But obviously the company has to keep track of the rate or frequency of sales and costs to keep profits increasing. The two have to stay synchronized to keep profits increasing.

How is this done now?

Mark to market question that should be asked more often

After yesterday's SEC hearing on mark to market, I'm hoping the message is getting through that this is a rule without a reason. Isn't the name itself inappropriate? For when an asset is marked to a "market" value without any transaction having taken place, the value is NOT a market value at all, but rather a pro forma estimate, and a bad one at that since it will not usually include consideration of the total volume and liquidity of the asset in question.

Are short time horizons reinforced by the media?

I'm not a CFA or registered broker agent, so this isn't investment advice. But have you noticed that at the same time that short-term treasuries have been at historic lows, the long-term treasuries are very low also? Sure, the story about 1, 3 and 6 month t-bills makes for great headlines -- those are dramatic cliffs in mid-September. At the same time, there hasn't been the volatility in the longer-term notes. 30 year notes, for example, are still hanging around 4 percent, where they've been all year.

Which demonstrates quite vividly that nobody really believes that the equity market isn't going to resume a normal, sustainable (8% to 15% depending on how optimistic you are politically) rate of growth over the next 30 years. Yet most investors are not ready to jump into the equity market for the long-term (as the short-term rates ably demonstrate).

Again, I'm not an investment advisor or macroeconomist by training, but the money being used to buy short-term notes will have to go somewhere within the next six-months when those short-term notes expire. Real estate, like all assets whose value isn't fundamentally derived from human capital, doesn't have the growth potential of equity. Debt markets will surely pick up for some high-quality issuers, including the manufacturers of staple commodities. But for long time horizons, equity is looking better and better as 2008 goes on. Besides that, selling equity now means you fail a basic test of investing -- if Warren Buffett is buying, are you buying or selling?

The difference between debt and equity

The authors at the excellent AAO blog complain that the government's terms under the Troubled Asset Relief Program" (TARP) strike a bargain that is more like debt than equity as far as managers and investors in the companies that accept the terms are concerned:

Take a look at the term sheet for the injection. The government plans to buy preferred stock, now in vogue. It'll carry a 5% dividend, rising to 9% after five years; it can't be redeemed for at least 3 years; restricts dividends on junior preferred stock or common stock; has no voting rights; and restricts executive compensation to be in accordance with the Emergency Economic Stability Act's requirements. One other thing: it has a "perpetual life," apparently because the term sheet says so. Realistically, the Treasury is not going to be a longer-term player in these preferreds any longer than it has to be - and there are no restrictions on the transferability of its investment.

Is this complaint sound? Yes and no. At this point in time, there's no way to argue with the facts they cite in evidence for their reasoning. But it's important to remember how we got here. Fifty years ago, most public companies paid a substantial dividend to their shareholders, and holding preferred shares was a good way to invest in smaller or struggling companies whose common dividends were not secure. With the shift away from paying dividends toward reinvestment of free cash flow, the significance of the distinction between preferred and common has diminished. Thus the recent suggestion of some on FASB that only common shares should be considered equity.

Some readers may argue that tax efficiency is a justification for retaining earnings. Maybe. But on my view, if a company can't earn more than a dollar for each dollar it reinvests, then it should give me my cash and pay taxes rather than keeping some pet project on life support. I don't like taxes, but the government is setup to spend them -- and is subject to more checks, balances, and transparency into its spending.

Nitty Gritty Details on Subprime Securities

For those interested in doing a deep dive into the details of how and why subprime mortgages were securitized into the various tiers of of MBS, CDO, and CDO^2, I recommend this paper by Gary Gorton, who did this work at AIG. Thanks to Tyler Cowen for the link.

Underappreciated Cause of the Crisis

The same rapid technological advances that are driving the marginal cost of information dissemination and trade execution to zero may also have implications for the incentives faced by information producers. As trading costs fall, the marginal investor may be becoming less experienced, less sophisticated, and less able to derive fundamental security values from raw information. At the same time, the characteristics and business models of publicly traded companies are changing as the economy itself changes. Newly listed firms are far less likely to generate sufficient cash flows in the near term to internally finance the costs of expansion and compensation. A high current stock price becomes a vital cash substitute for these firms. These trends combine to create strong incentives for firms to distort the information they produce to the investor community. We show that, indeed, there is evidence of deterioration in the quality of information that firms supply to investors. This deterioration may slow down the improvements in security markets that technological progress brings about. Moreover, private mechanisms such as litigation and information packaging by financial intermediaries are unlikely to solve the problem of information quality. Investor education and the regulation of information disclosure in particular may therefore play an important role in the development of securities markets in the foreseeable future.

From Technology, Information Production, and Market Efficiency by Shleifer et al.

Here are few interesting charts from the paper:

The units for the y-axis here are percent of average firm assets.  Discretionary accruals are basically adjustments to cash flow permitted under GAAP.

Is there any correlation between how many discretionary accruals are used and future returns?  Yes.

Accounting rules need to be made simpler.  Corporations must be required to report more information, not less.  Intermediaries who process financial statements and other accounting information produced by publicly traded corporations need to be independent of the investment banks or other insitutions that finance publicly traded corporations.

Would you still read Consumer Reports if it were paid for and published by GE, GM, and Dell? 

Balance Sheet Ignorance Revisited

A few months ago, I posted Why Does Wall Street Ignore Balance Sheets?

I was pleasantly surprised to see this Forbes column by Columbia B-school professor Partha Mohanram has picked up on the same phenomena.

Improved accounting rules could make the relationship between balance sheets and income statements (or better yet cash flow) more transparent.  But ultimately, everybody in the cycle of purchasing and sales of stock is responsible for ensuring that the additional information is used to promote sustainable growth.

Is there some kind of competitive pressure that we could put on the entire market mechanism that would serve a disciplining purpose similar to the competitive pressure on companies within the market?

SEC Roundtable on Modernizing Disclosure Rules

On October 8th the SEC is hosting a roundtable to discuss how the current disclosure rules and system could be modernized.  If you're in D.C., it might be worth putting in your 0.02 euros.

There are a few companies here in Silicon Valley that should be flying people to this roundtable, although I doubt they actually are.

Best of Bailout Commentary

Best bailout commentary I've read so far:

1. Robert Shiller on the role of government within our evolving economic ecosystem.

2. Judge Posner explaining in plain English how the web of contracts stretching throughout the financial system correlated risks that the same contracts were intended to keep uncorrelated.

Best solutions I've seen suggested:

1. Abrogating FAS 157 and putting the SEC in charge of accounting rules (rather than the FASB).

2. Make public firms simply report everything (i.e., the entire time-series of journal entries for each balance sheet account) along with their financial statement summaries.  Internet technology means that the market can handle and process more information than ever before.  Make it available.  (I advocated a similar change to the SEC rules back in July.)

I think it's wonderful that the bill was defeated in the House this morning.  I really could care less if weaker companies fold because they can't convince any banks to extend credit.  There are a lot of other forms of credit for good companies.

On why mark-to-market rules are the main culprit in this crisis

There is so much confused commentary about the bailout that I thought it might be helpful to make a very simple observation, which is neither novel nor complex:

Markets fail when buyers or sellers fail to gather or process enough information about what is exchanged.

That's it folks.  That's what triggers a stock market crash, a bank run, a bailout, a bankruptcy.  It's a failure at information gathering or processing.  Why?  Because markets are, at bottom, a mechanism for compacting the multitude of individual valuations of what is exchanged into a single number for each transaction.  That's what they do.

Mark-to-market rules (such as FAS 157), along with any other accounting or securities rules that limit the amount of information available to investors or the public, are going to make market failures more likley.

For non-specialists in accounting, the information that mark-to-market rules obscures is cost.  Under the mark-to-market rules, investors cannot simply compare the present market value of assets against the book value in order to determine the profits likely to obtained.  Instead this is done for them by accountants inside the company, and it is up to the investors to sort out how that was done.

Profitability, Accounting Rules, and the Evolution of Corporations

I'm in the middle of reading Evolution for Everyone by David Sloan Wilson, an excellent summary of his teaching on evolutionary theory, which claims to show, among other things, "that evolution and religion, those old enemies who currently occupy opposite corners of human thought, can be brought harmoniously together."  That's a subject for another post (or several).  Readers interested in that claim should see a few posts I've done on another blog here and here.

An important fact presented by Wilson is that the traits of individuals evolve very differently when selective pressure acts at the level of groups (that include individuals) rather than on individuals directly.  That's a little abstract, so here's an example taken right out of his book:

Chickens have always lived in groups, and in the modern egg production industry they are crammed inhumanely into cages usually containing nine to twelve hens.  [Biologist William Muir] wanted to increase egg production by selective breeding, and he tried to do it in two ways.  The first method involved selecting the most productive hen from each of a number of cages to breed the next generation of hens.  The second method involved selecting all the hens from the most productive cages to breed the next generation of hens.  You might think that the difference between the two methods is slight and that the first method should work better.  After all, it is individuals who lay eggs, so selecting the best individuals directly should be more efficient than selecting the best groups, which might include some individual duds.  The results told a completely different story.

When Bill presented his results at a scientific conference that I attended several years ago, he showed a slide of hens selected by the first method after six generations.The audience gasped.  Inside the cage were only three hens, not nine, because the other six hens had been murdered.  The three survivors had plucked each other during their incessant attacks and were now nearly featherless... What happened?  The most productive individuals had achieved their success by suppressing the productivity of their cagemates.

By contrast, the second method resulted in higher production, and a cage that looked almost happy.  If group selection could have such a dramatic impact on egg production, what impact might they have on the characteristics of individuals and groups in other situations in which group selection criteria are at work?

Consider the ecosystem of publicly traded corporations.  There are obviously many selection criteria at work here.  But by some measure, it seems safe to say that the profitability of a corporation compared with other corporations in its industry group is one of the most important in determining long-term survival.

At first glance, one might think that we've (quite by chance) landed on the best selection criteria from the point of view of promoting good social norms in business.  Upon reflection there are several difficulties in reaching that conclusion, and even casual observations of differences in industry norms might suggest another.

The problem is that there are many different ways of measuring profitability.  At least under current practice, most public information about profitability is reported by the corporations themselves.  In other words, profitability is not measured by the public, but rather by the agents of the corporations who are responsible for profitability.  Anyone can see how this could transform what should be a group selection criterion into an individual selection criterion, and in turn how that might have some very bad results both in individual cases and for the industry as a whole.

How to remedy this?  Seems like the easiest way to do this is to require corporations to report all raw data to the public in addition to their summary of that raw data in the form of financial statements and notes.  Why would this work?  Most people won't bother with the raw data.  But a few will review it and confirm that the summaries are accurate.  There are more than enough investors out there now for that processing function to be performed.  And the result will be that strategic behavior by individuals in the form of "creative accounting" will be dramatically reduced by the increased scrutiny of their actions. 

How firms can grow faster by optimizing profit and time independently

My contribution to the Creative Capitalism blog described how Schelling revealed that profit maximization is only one focal point among many that can be used to achieve cooperation among, and suggested that time optimization is another, which could have an equally large impact on long-term growth within economies. There wasn't room to elaborate there, so I thought I'd followup here with a quick explanation for how this might work within a corporation.  Later I might provide similar explanations for how other institutions (including families, churches, or non-profits) are already better optimizing their use of constituents' time.

A good starting point is the time-series of revenue into a firm.  On financial statements, this time series shows up as a time-integrated sum of the revenue for the period.  Right there we have an instance of how financial statements could be improved.  Why not show the entire time series instead of just the sum?  I'd like to know if there were major fluctuations, wouldn't you?

As Sean Macnew does a good job explaining here, an excellent management accounting technique is to break the revenue stream up into units of goods sold multiplied by price.  (Revenue = Price * Quantity).  Notice that the traditional supply and demand curves from introductory economics are plotted in terms of price and quantity.  Notice that only the point on these X curves where the curves cross is relevant, however.  The plots of supply and demand from introductory economics are not plots of supply or demand as a function of time.  Rather, they are cumulative distribution functions that show the frequency of consumption and production within a given market.

Sean explains how parametrizing the revenue time-series into key independent variables within the firm can help in identifying bottlenecks in production, thereby reducing costs or increasing quality (and hence price).  In the comments to his posts, I suggested the Fourier transforms of the time-series might be useful as well.  Why should that be?

Because in many cases, the time-series will not be a smooth, monotonic function.  Rather, it will oscillate downward as costs of sales are booked as expenses and upward as sales are booked as revenue.  Within any given window of time (say 1 month or 1 week) the frequency of these oscillations can be determined by doing a discrete Fourier transform (such as an FFT).  By comparing that frequency with the frequency determined for a different period, managers can determine whether activities within the firm are speeding up or slowing down.

Why is that useful?  Managers are constantly trying to determine where additional time and money should be spent to increase revenue.  The comparative frequency of different activities within the firm gives a fairly direct insight into whether a point of diminishing marginal returns has been hit already, or whether additional resources are unnecessary since the frequency of some activity is still increasing from period to period.

My dream is for all firms to implement more sophisticated internal controls over both time-averaged costs (such as sales and costs of sales) and frequency-averaged measures of activities relating to revenue and expenses.  I'm confident that most firms would operate more efficiently over longer periods of time and more widely dispersed scales by implementing these types of measurements.

What's new in professional accounting?

Based on the AAO blog's summary of the latest "complexity committee" report from the SEC, not much.  This is truly unfortunate.

Notice that none of the proposals involve providing more information.  Professional accountants are afraid to give the raw data to investors without their summaries and editing.  This is silly.

About a month ago I suggested that companies should start providing the full time series of debits and credits for each balance sheet account with their financial statements.  Let the market do the editing and summarizing.

Does encouraging consumption or government spending promote economic growth?

No.  It's efficient allocation of capital through voluntary exchange, and the efficient allocation of human capital through divisions of labor that promote economic growth.

The vulgar Keynesian prescription is to encourage consumption, when a dynamic of precautionary storage takes hold. And in extremis that might be a good idea, because if all everyone does is hoard, it's hard to figure what to invest in, except maybe storage tanks. But it's much better to develop a financial system that actually performs, that identifies fruitful projects and allocates claims fairly. Storage eats wealth, while productive enterprise creates it. People know this. No one "invests" in gold or oil when a financial system is working. They do so when it is broken. Like now.

That's Interfluidity found via Tyler Cowen.

Maybe better accounting theory would help?

Waddell & Bodek on the End of the Quarter (or Year) Shuffle

During those last few days of the quarter, all the stops are pulled out to make the numbers.  Some of what is done is downright illegal.  Much of it is unethical.  Just about all of it is senseless.  However, management salaries and promotions are driven by numbers.  Plants are closed or kept open based on the numbers.  Work is shifted from America to China and India based on these numbers.  The numbers, unfortunately, are not based on sensible economics or what is good for the long term health of the business and its various stakeholders.  They are based on Wall Street schedules and balance sheet targets

Most plants have been through the drill so many times that the people need very little coaching.  All the way down to the operators on the production floor, the people know how to rig the numbers.

Every machine and every production employee will run all-out if there is anything in the plant for them to work on.  Supervisors who are normally lenient concerning breaks will become frenzied taskmasters.  Of course, there will be no employee safety or quality meetings.  Nothing will keep production people from their machines on the last few days of the quarter.

...

Quality inspection will virtually shut down.  If anything produced is bad, no one wants to know about it until next week -- after the books are closed on this quarter.

This passage does an excellent job of revealing the connection between quality and periodicity.  Smaller fluctuations in frequency are probably correlated positively with quality.  Quality is difficult to measure.  Periodicity not so much.

How to Call a Bluff

JP Morgan CEO James Dimon is challenging the numbers reported by other investment banks that are meant to reflect the stability and health of their balance sheets.

Talk is cheap.  The way for Dimon to make his point is for him to post his own balance sheet information up on the internet for any interested investor to scrutinize.  Let the other banks do the same if they really stand behind their numbers.

In Rome, they made the architect stand under the arch when the scaffolding was removed.  The difference between Roman architecture and modern accounting is that more lives depend on the accurate reporting of financial statements.