Fearful Asymmetry: Balance Sheets and Managers

The surest way to kill a metaphor is to explain it.

Nonetheless, let me try to explain the title of this website, Fearful Asymmetry. It plays, of course, on the opening stanza of Blake’s poem, The Tyger:

Tyger Tyger, burning bright,
In the forests of the night;
What immortal hand or eye,
Could frame thy fearful symmetry?

Symmetry in accounting is represented by the balance sheet. Everything a corporation owns balances exactly with everything it owes. Perfect symmetry.

Except that it’s not really symmetrical. The side that shows what the corporation owns, its Assets, is a simple list of the value of its cash, inventory, trucks, factories, land, and so on. It may be divided into short-term and long-term assets, but everything listed is some kind of asset. The other side is not one list, however, but two: Liabilities and Shareholder’s Equity. These are very different beasts.

The first glimpse I give my students of an accounting statement. You have to start slowly when you are teaching accounting. Some of the students are terrified.

The first glimpse I give my students of an accounting statement. You have to start slowly when you are teaching accounting. Some of the students are terrified.

The liabilities section shows how much the corporation owes everyone except its shareholders. The shareholders’ equity section shows is how much it owes its shareholders. These two sections together add up to the same amount as the assets. So, both sides of the balance sheet have the same value, but because of stark differences between liabilities and equity, they are presented in a way that is asymmetrical.

Liabilities are, generally speaking, limited by some sort of defined obligation. The corporation has to pay back a bank loan, for instance, or pay a supplier for specific goods purchased or services rendered, or remit the sales tax it has collected. Once a liability has been repaid, that's the end of it.

The equity section, in contrast, is an open-ended obligation. The shareholders are owed not just the money they paid the corporation for their shares, but all the profits the corporation has accumulated since it started doing business. This obligation keeps growing each year as the corporation earns profits.


If not now, when?

Liabilities and equity are different in another way. While a corporation is legally obliged to pay off its liabilities, it is under no obligation to pay the shareholders anything as long as the business is still running. It is quite entitled to hang on to the shareholders’ money and reinvest it in the business.

In fact, in many companies, this is exactly what the shareholders want. It would not make sense, for instance, for investors to pony up money for a high tech start-up, and then have the company just give the money back. The whole idea was to launch a new business. The investors want the managers to use the money to start and run the business. They want them to take appropriate risks, design great products, collect lots of revenue from customers, and pay only the expenses necessary to make all this happen.


Information Asymmetry

So how do investors know the managers are doing these things? This is where the other aspect of asymmetry comes into accounting. Investors could, in theory, visit the company to see what is happening. But no matter how frequently they might meet with the managers, the managers will always know more about what is going on in the company than the investors do. This is referred to as information asymmetry. Managers will always know stuff that the investors don’t. And this scares the crap out of the investors. Hence, the word “fearful” in this website’s title.

It’s quite possible, history tells us, for managers to use a corporation’s money to buy themselves shiny cars and fancy houses, or trips to exotic locations. Like Sudbury, home of the largest coin in the world. Managers could easily claim that this money was spent for business purposes, and investors would be none the wiser. The investors might eventually be disappointed that the company was earning less money than anticipated, but they wouldn’t know why.

In my next blog post, I’m going to explain the constraints that accounting imposes on managers to deal with information asymmetry.

PowerPoint slides are a great way to kill learning. Use with caution.

Photo of Sudbury Nickel is from Wikipedia. I have my own picture somewhere, but I can't find it.