Summary
Bubbles may be persistent throughout human history, but accountants can play their part in preventing or curbing the worst excesses.
Bubbles occur when investors trade on the basis of the market value of an asset, rather than on the business value it creates. Believing that someone, somewhere will pay more for the asset in future, expert and non-professional traders can be drawn into investing based on upward market trends, fueling upwardly spiraling prices. Cheap credit only serves to exacerbate the bubble.
Although accountants may not be directly responsible for bubbles, they can contribute to their development. The complexities of accounting can cause fluctuating asset valuations, encouraging investors to believe prices will rise. Additionally, when assets are valued at market rates in company accounts, their fundamentals can appear stronger than they are, which again feeds investor frenzy.
This paper examines how and why bubbles evolve, and considers what accountants can do to try to prevent bubbles, or at least reduce their frequency and magnitude.
Highlights
Bubbles have consistent themes:
- The assets underlying the bubble were bought and sold many times before being used
- Ready availability of investment capital adds to the problem
- Many untrained investors are drawn into the bubble, increasing speculation
Investor behavior is hard to predict:
- Investors tend to overestimate what others will pay for an asset
- Investments can be mispriced due to an asset’s market price deviating from its fundamental value
- By relying on market trends to value assets, investors continually elevate the price, creating a bubble
What can accountants do to help?
Our research suggests that historical cost accounting – as opposed to marking to market – can reduce the potential and subsequent impact of bubbles and crashes. Accountants can provide better accounting information, emphasizing an asset’s true, fundamental value, and remain cautious about market-based estimates of asset value, helping clients to recognize the warning signs of impending boom-and-bust cycles.