1) In a transaction taking place in 2004 you sell something to someone, and you are proposed, in payment, to receive either 100 euros today, or a promise to receive for sure 105 euros in one year. What do you prefer, and why ?
A transaction is always an exchange of two things, AT THE SAME TIME. This is true in Finance, as well as in Accounting.
Accounting is difficult to understand so long as we overlook this fact. If we use the standard way of thinking : “I sell something, therefore there is one account involved, here it must be the Sales account…” we are mislead. We must look at the two movements : something leaves us, or our firm (it’s a sale), and something enters our firm (the payment : cash, cheque, IOU, promise of one sort or another). But it takes place now.
In business, and economics, we study EXCHANGES. Even production is done through exchanges : purchase of labour, and of raw materials, to produce products, and then the sale of them.
We live in societies based on exchange. The power of exchange has proved very strong to create wealth and to consume it. Between the beginning of this lecture and its end, in three hours, the population of the world will have increased by 30 000 people. Our lives are pervaded with values related to exchange : consumption, ads, prices, supermarkets, efficient production, etc.
The whole purpose of Economics is to study the conditions to create prosperity (production and fair distribution) in societies. In Economics courses, in schools, we learn conventional economical knowledge, that studies exchanges governed by “the law of supply and demand”. But everybody knows from experience that it does not apply well to reality. That’s one of the reasons why Economics is called “the dismal science”. For instance Adam Smith said that, in a group exchanging, an invisible hand (that is, a system) leads, via the selfish behaviour of each one, to the well-being of everyone… The reasoning goes as this : “If there is a lack, and therefore a demand, for a product, the prices will go up, suppliers will appear, attracted by the profit, they will make money, and then the suppliers and the rest of the community will be satisfied…” Everybody knows it doesn’t work like this in real life.
Put 100 people together in a community and let them exchange. Relations of strength will appear parallel to exchanges. These are related to personal values next to "common values". When we exchange a product A for a product B, it is because we have a personal value for A higher than for B (and normally it is the other way around for the other person). These personal values can lead to relations where we are in a weak position and are forced to accept the exchange. Relations of strength pop up at first from chaotic phenomena. And then they shape the structure of the community.
Economics studies complex systems created by exchanges in a community. It leads to complex dynamic structures. To some extent exchanges lead to more production. But it does not lead to fair distribution. This has nothing to do with good and evil. It is social dynamic. Exchange mechanisms lead to the emergence of complex structures. That is exactly how life appeared 3 billion years ago : special types of molecules formed proto-cells simply because they were partially hydrophobic (like soap). Then, much later on, when they had become eukaryotic, they began to form multicellular bodies, and these bodies began to specialise and to exchange, within each other and between each other. Exchange is the engine of life, but it doesn’t lead to uniform prosperity, it leads to complex structures.
Everything we study in this program, for three years, has to do with the study of exchange to create wealth, prosperity and fair distribution. Commerce means exchange. In fact these topics are very hot topics nowadays in the international community. Questions like :
Should the international community
· Should the World Bank impose market economies to countries asking for its help ?
Firms are social entities to create wealth. It is done via exchange. Then this wealth is distributed via the mechanisms of money, and prices. The well-being of our societies rests in part on these mechanisms. Accounting is just a set of simple techniques to record exchanges (products and values). It is not concerned with the time value of money. Not so in Finance.
When I give away something with the promise to be paid later, I receive TODAY this promise, usually it has some material support (a piece of paper, some legal proof…)
We prefer, in payment, what has the more value.
What has the more value ? 100€ today or a promise for 105€ FOR SURE in one year ?
Ans. : 105€ for sure in one
year ! Why ? Today in
If I have a promise for 105€, for sure, in one year, in my pocket today, I can sell this to someone else for 103€ ! It is definitely better than 100€.
that price today of 100€ to acquire the future CF of 105€ becomes a normal price to us or even too high a price if the future cash flow is a random variable (at least that's how financiers reason)
why the hell would anyone give us, in exchange for 100€ given to him or her today, a promise worth to us more than 100€ ? Ans. : that is where personal values and prices, and relations of strength enter the picture.
It is when we overlook that we compare two things AT THE SAME DATE that we begin to be confused. We give today a product, and we receive TODAY either 100€ or something else (namely a piece of paper that is a promise, to receive 105€ in one year).
This also applies to accounting : accounting becomes very confusing when we overlook the fact that a transaction (the elementary operation of a firm, that is, an elementary operation in the process of creating wealth and of exchanging wealth) is TWO MOVEMENTS (one in and one out) AT THE SAME TIME.
One difference between accounting and finance is that accounting is not concerned with the monetary difference of value between 100€ of cash today, and a good client paper promising to pay 100€ in two months. We use the historic cost rule for our recordings. We know its drawbacks, but it is very robust, and has proved useful.
Accounting makes casual use of money. Finance makes a more sophisticated use of money (cash). Money is a more complex and elusive concept than appears at first glance : money is value that can be exchanged readily with no effort to convince the other party ; either it has "value on its own" (like gold used to have) or it bears a signature and therefore it is worth as much as the trustworthiness of the signatory ; banknotes bear the signature of a State's monetary authorities, and are legal tender within that State, but that does not give them automatically "absolute value" (the Rubble used to be worth one dollar, now it is worth 3 cents) ; modern developed countries governments tend to be irresponsible with the management of money (they issue it, or promises, to finance deficits to maintain their electoral base ; that's the drawback of modern democracy : clientelism ; in fact "clientelism" is everywhere : it is the use of own's power to obtain as much as possible ; when a purchaser chooses a supplier there are few effective barriers to prevent the supplier from paying nice holidays to the purchaser in order to be chosen ; the same applies to governments ; the same applies to academic elections : academicians select new entrants that will advantage them, serve their interests, be their "obligés" ; that's social dynamics and relations of strength to maximise one's well being).
Economics is still fraught with concepts of good and bad. This is a characteristic of immature sciences, to be full of values and concepts dating from the time when priests and philosophers were the people in charge of describing the world. They did it, but did not always took the pain to look at it first. They mixed up “common sense”, personal convictions, and social purposes. Aristotle claimed it is obvious that heavier bodies fall faster… Their motivations were of another nature than sheer knowledge. There are ideas, nowadays commonly accepted, that were mindblowing and unbelievable to man 500 years ago : for instance, the world is not flat but a sphere floating in space, and people and waters underneath us do not fall… If we think of it, it is unbelievable we even accept this. Another example of idea quite ununderstandable today is this : the concept of time, as we know it, does not apply to very long periods in the universe, and to talk about what happened earlier than 20 billion years ago is meaningless.
The same will happen in Economics, and in Finance, particularly concerning Money.