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Monday, April 15, 2019

QUICK RESPONSE TO DEAN


Dean asks:  “Why is the suggestion "that the company write off the entire cost of the machine in the year it is purchased, and treat it in all the subsequent years of its use as a free good" not objective and impartial? As for inventory, wouldn't the objective, impartial valuation be the actual price paid for each unit used? Sure, that would be a cumbersome, inefficient method, but it would be objective...wouldn't it?”

The problem is that all of these alternative schemes are objective, but none of them is impartial.  None is dictated by the market, so the company must choose among them, and each choice benefits some persons in the management of the company and disadvantages others – i.e. each is in a sense an internal political choice.

For example:  Suppose the item to be written off is an air conditioning system with an expected life of ten years.  If it is entirely written off in the year it is purchased and for the next nine years is treated as a free good, then a division chief who was appointed in year three gets seven years of free air conditioning, which decreases the costs of her division for that time, as compared to the chief of a different division who was appointed the year before the new system was installed and had to take a share of that cost against his division’s profits.  And so forth.  All the alternative accounting conventions are objective, in the sense that they do no rely on someone’s subjective estimate of the value of having air conditioning, but there is no impartial basis for preferring one scheme over another.

As for the pricing of inventory, LIFO, FIFO, and so forth are all objective, but as I indicated, one favors one branch of management [or one group of investors] and another favors a different branch.

2 comments:

Dean said...

Thank you for this helpful response. It generates more questions, but I'll try to think through them before posting any.

Dean said...

My questions boil down to, "What does 'dictated by the market' mean in this scenario?" Put another way, if an action is dictated by the market, is it by definition not impartial, i.e., the action won't treat different parties differently, and so the manager won't suffer the dilemma of choosing between competing managers?