§1. In part 1 of the blog, we have seen that the unit is name given to constant characteristics. Number is assigned to that constant characteristic and we should change them whenever such characteristics changes. Numbers can not operate in different units at a same time.
§2. This basic construction is to discuss monetary unit, so called money price. Price of anything is used to transact goods or services at individual level, or price itself is the ratio between goods or services to be transacted. These prices as shown by marshal is marginal price and always leave room for change. For reality reflection of such transactions, these prices are good enough. As nothing can be transacted at buyers price or suppliers price, rather equilibrium price in that local market, or market connected by information network.
§3. The problem I am about to discuss is the financial information contained in financial statement. Problem become serious in balance sheet, where assets and liabilities are recorded. Liabilities are perfectly reflected in their economic substance by historical cost, which are transaction prices. We should note some provisions and tax liabilities which are little different and are expected future transaction price. Hence, assets recorded in transaction price is the main problem.
§4. To explain assets and its relevance at year end, Profit or loss statement is required. In that statement, revenue is the asset gained (money can be asset at individual level), and all cost are asset given up or promised to give up. Hence, asset price shown in balance sheet is the only tricky part in net worth valuation of the company. (Discounting is not part of balance sheet, hence not discussed here)
§5. As Irving Fisher (most probably) showed, value is number of asset (with its quantity) multiplied by price. At transaction date, cost of asset, i.e. transaction price reflects the economic substance. However, balance sheet is prepared at year end and published at later date with some assurances. That piece of information is used to value the company, and marginal price in share market becomes the price of share of that company. Players of the market, later adjust that number based on new information at their disposal.
§6. Financial numbers in balance sheet, of asset also, are composed of 3 things, number of time some physical quantity repeated * physical unit * monetary price per physical unit. Two out of three always remain constant, unless otherwise used, number of physical quantity and physical unit of quantity. Price however, itself a number, is used as monetary unit. In fact, only disclosed numbers are the multiplication results of above components.
§7. Now marginal price and economic decisions should be discussed. Price is the exchange ratio between goods and services to be transacted. We can always show, transaction happen between two parties, buyer and seller. The price paid or received is the marginal price, though they can have their own prices in the market. This gives room for consumer surplus and supplier surplus. If their is consumer surplus, buyer can go further to benefit and similar case for supplier. Hence, transaction price itself is unable to reflect future economic benefits. It only shows, economic reality of transaction at transaction date.
Economic decision of consumer is to maximize utility, given the budget constraint. And that of producer is to maximize profit by minimizing cost of production given budget constraints, etc. For an individual buyer of equity share it is to maximize return of that piece of paper. For a sound decision makers, to obtain equal or more than market return for that industry financing. As equity share is nothing but propionate ownership of the company’s net worth, decision depends upon assets that company hold. To adjust arguments of service industry which depends more on Human Resources than capital, we can say their asset enjoyed more surplus than market, hence keeping balance sheet discussion alive.
§8. From §7, we have seen the problem (probably), we are using money price as unit for assets, which only reflects marginal price at transaction date, and these marginal prices are not constant units also. Thus asset shown in balance sheet can’t give units at decision making date (probably later than even mark to market price date) and economic surpluses that can be enjoyed by current economic players at decision making date as resources are already given up.
§9. It will be costly to track prices of asset already purchased and to publish them daily. However, it will be more beneficial to break up value in balance sheet into its components, so that both financial capital and physical capital will be available at disposal of decision maker. And auditor must focus on physical capital too, while performing audit procedures. Existence and accuracy of marginal price are two most important assertions which must be verified. Though marginal prices of past may not be that useful of tool to make economic decisions.
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