One of the courses I did at business school was “Analysis of Financial Reports” where we learned to deconstruct all the scam accounts that had proliferated in the late 1960s boom – most of which companies, undone by negative cash flow, went bust after 1970. We were informed by the professor that the Financial Accounting Standards Board, set up in 1973, was introducing new and more rigorous accounting principles, so that pretty soon all the accounting scams of the late 1960s would become impossible, and accounts would become readily comprehensible, with few differences in approach between the accounts of different companies.

Well, that didn’t last long!

Since the 1970s, not only has finance become vastly more complicated, but so has accounting. The principle of “mark to market,” originally introduced only to value properly the trading portfolios of securities brokerages, has been extended again and again, until it makes accounts incomprehensible to the ordinary investor. Combine this technique with the complexities of modern finance, where derivatives are used to “hedge” all imaginable operations, and you see perfectly simple, “vanilla” companies suddenly record huge profits or losses for no conceivable reason. You also saw banks recording spurious large profits in 2008, as their credit quality collapsed and the “mark-to-market value” of their liabilities declined commensurately.

Then add to that the skewed incentives produced by a decade of negative real interest rates, and the ethical decay of managements who know that the regulators are plodding along at least five years behind them, and you have accounting visibility below that of the South Sea Bubble days. Needless to say, the prospects for mass fraud and chicanery are even grimmer than in 1720.

In the third quarter of 2014, for example, the iron and coal mining company Cliffs Resources (NYSE:CLF) was forced to take a $5.7 billion charge (net of tax — $7.7 billion gross) on its coal and iron ore fixed assets. This charge was forced, not because of any long-term change in the coal and iron ore businesses (though admittedly the U.S. environmental regulations on coal-fired power stations are a long-term threat to the coal business) but simply because the prices of both commodities have declined. On an operating basis, the price decline did not result in Cliffs making heavy losses which might threaten its survival; the company recorded a modest operating profit in the quarter.

As a result of the accountants’ markdown, Cliffs’ equity was reduced from a comfortable $6.9 billion (against which $3 billion of long-term debt looks manageable) to a ridiculous minus $177 million – on a book accounting basis, the company is balance-sheet insolvent.

But in the real world, this makes no sense at all. Fixed assets which were before September valued at $11.1 billion – presumably approximately their historic cost – are not suddenly worth $3.2 billion. To replace them today would presumably cost considerably more than $11 billion, not less, although they are doubtless partly depreciated.

The short-term decline in iron ore and coal prices does not suddenly make those assets worthless; they are expected to earn income over a lifespan of decades, and that income can reasonably be expected to fluctuate depending on mineral prices. Over their life of say 40 years, periods in which, as at the present, their earnings are low will be balanced by periods such as 2010-11 in which owning those assets produced a bonanza of profit and cash flow, available only to those who already had such assets in place and in full operation.

If another company, or more likely, a fly-by night private equity operator wanted to make an offer to Cliffs for its shares, it should economically take account of the true value of Cliffs’ assets, not their artificially written down book value. Maybe it would not have to pay quite $11 billion for the fixed assets, but it would have to pay a considerable premium over $3 billion. Indeed Cliffs’ current market capitalization reflects this to some extent; at $1.7 billion based on today’s $10.92 share price it reflects an infinite premium over Cliffs’ negative book net worth.

The danger for Cliffs’ shareholders is that the false value imposed on their assets by the accountants weakens their bargaining power against a corporate raider. Whereas a takeover offer at say $15 per share would look ludicrously low compared to Cliffs’ pre-September book value of close to $40 a share, or even its “true” net asset value in today’s depressed markets of perhaps $30, it might, given the company’s minus $1.20 per share book value, tempt the more foolish speculators and arbs to sell out, ripping off stable long-term Cliffs shareholders. Needless to say, accounting should not be in the job of perpetrating these kinds of short-termist games.

There are other examples of accounting hopelessly obscuring the economic reality. The energy MLP Linn Energy (Nasdaq:LINE) in 2008 pulled off an economically brilliant move when it hedged the output from its oilfields three years forward in the futures market at a price of over $100 a barrel, a level the oil price was consistently below over the next three years. As a result, however, its financial statements during the hedge period were distorted beyond belief.

In the last quarter of 2008, when oil prices fell to a low of around $30, LINE reported a gigantic profit, even though the value of its oil in the ground had collapsed. Then as oil prices rose gradually back to their 2008 level, which they hit in 2011, LINE was forced to report consistent losses, even as its reserves were gaining value and the oil it produced was being sold for an excellent price through the hedges. For shareholders, it became impossible to determine the two most important factors on an MLP of this kind: whether the oil reserves in the partnership were being fully replaced and whether the operating income from oil sales, net of expenses, was sufficient to cover the hefty dividend the partnership was paying.

Another example: Thompson Creek (NYSE:TC), a company in which I have shares, reported an excellent operating third quarter of 2014, as its new Mount Milligan gold and copper mine ramped up. On a “adjusted EPS” level reported by management its net income was 17 cents/share, an excellent quarter for a company with shares trading below $2. However the company had an unexplained $60 million foreign exchange loss on intercompany notes (it is domiciled in the United States, but the majority of its operations are in Canada) resulting in an overall loss on generally accepted accounting principles. If the notes were intercompany, then the group presumably benefits from exchange movements (I assume CAD/USD) by the same amount it loses, so why the spurious charge, which obscures the reality of TC’s operations?

The insistence by accountants on obscuring reality through the vagaries of “mark-to-market” is leading managements to report their results to shareholders on a non-GAAP basis, in theory to reflect the true economic reality. Of course, this dual reporting itself is subject to egregious abuse. For example Tesla Motors (Nasdaq:TSLA) according to its official financial statements made a loss of $75 million in the third quarter of 2014. Mark-to-market was not involved (it plays a much less important role in consumer products companies than in resource companies, unless they are playing merry hell with derivatives.)

However the quarterly report then focused on a “non-GAAP” net income of $3 million, which excluded not only the costs of Tesla’s very expensive program of assuring the future resale value of its products, but also the stock options given to management and, extraordinarily, debt interest (presumably the last exclusion, while completely spurious, served to tip the final number into a small profit rather than a loss.) To the extent Tesla shareholders believe the company’s “non-GAAP” earnings number they are in for a very nasty shock when they discover how they are being diluted by management stock options and, more important, when the very large costs of Tesla’s resale price guarantee program kick in from 2017 or so.

The purpose of accounting is to reflect to shareholders a realistic picture of the company’s operations and its assets. There will always be distortions; for example in the inflationary 1970s buyout artists were always on the lookout for companies whose headquarters or main plant had been recorded at cost in say 1926 and not revalued since. However “market to market” of fixed assets in particular destroys the historical record of how the company has been built, and makes all subsequent earnings and asset figures both meaningless and impossible to relate to either reality or competitors’ operations. (For example Cliffs’ operations will show an artificially low depreciation charge in future quarters, making it impossible to determine its true costs compared to competitors.)

The financial and economic system has in the last 20 years been distorted beyond belief by artificially low interest rates, excessive leverage, and countless fast-buck hedge fund and private equity fund operations sustained by the financial bubble. The costs of these distortions have been enormous, and will be paid for decades to come. The accountants have contributed greatly to this mess. The profession needs to get its house in order, fast.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)