Accounting Shame

In Criticism, Financial, Popular Posts on April 7, 2009 at 6:24 PM

The Financial Accounting Standard’s Board in the US decided that it would relax the rules on Mark-to-Market accounting. I touched on this concept only briefly in a previous piece (Toxic Plan), but given what has transpired since, it is worth a more in-depth look.

The story begins with Geithner’s proposed plan to buy toxic assets. Regardless of whether this plan was good or bad for America, the purpose of the plan was get banks lending to distressed corporations by:

  1. Providing an incentive to private investors to purchase mortgage-backed securities from distressed companies (this includes banks as well as other corporations). By creating a market to sell these toxic assets, this would provide much needed liquidity to troubled companies that are currently stuck with the securities;
  2. Simply from having actual market transactions again, the entire mortgage-backed world has fresh market transactions with which to value these toxic securities. With existing mark-to-market accounting rules in place, the market values of these securities will rise on troubled balance sheets as a result of real market transactions.

There are many critics of the plan, and rightfully so, but among all the attacks, what has been lost is that Geithner’s plan works with existing accounting rules. If there are willing buyers for these toxic assets – whether a bank decides to sell them or not, all holders of toxic assets would benefit. The beauty of the mark-to-market accounting rule is that valuations of these assets were never entirely in the hands of the companies holding them. The value of these assets is a reflection of what an impartial investor is willing to pay for them.

However, Wall Street banks currently holding toxic assets don’t agree with the rule. They argue that there is no market for them today because of the financial crisis and it’s unfair to value them at zero or close to zero. They point out that if they were to hold these mortgage-backed securities until maturity, they would still receive 50-75% of the total underlying loan values, if not more.

[This is true. Assume a bank is holding one mortgage backed security that is made up of 5 mortgages valued at $200,000 each. If foreclosure rates go as high as 20%, which is outrageous, that means only one of the underlying mortgages is worthless – which means $1 million worth of mortgages should be revalued at $800,000. But this is in the long-term. Like, really long-term. It will probably take Americans 25+ years to pay down the entire mortgage, and some even had durations of up to 40 years. However, as long 80% of Americans keep making mortgage payments, this bank continues to receive interest and principal, every month, on the underlying mortgages of its mortgage-backed security]

So what the banks have asked for is the ability to set the value of these securities themselves. Despite Geithner’s plan, the Financial Accounting Standards Board decided that Wall Street is right. Rather than waiting for the market to come to the conclusion that these assets aren’t actually worthless, they have given the discretion to distressed banks. An accounting mechanism that is meant to correct itself has been usurped by the lobbying power of Wall Street big-wigs. I’m not exaggerating, this blog entry in the NY Times describes a disturbing account of how the rule changed. Not to mention, if FASB was going to change the rule, why didn’t they simply change it when banks needed it the most – last fall during the market collapse? What’s the point of doing this now, after Geithner already made a plan to work in unison with the old rule?

As an accountant, it’s disappointing to see this kind of a rule change. It’s a permanent accommodation of a temporary situation. Even if you agree that these assets have a different value if they were held until maturity, most companies that have been harmed by toxic assets need to get rid of them now, not 25-40 years from now. By putting the cart before the horse, companies holding toxic assets are hoping to boost their values up using subjective valuations. Although this won’t help them sell the assets, they are hoping it improves their balance sheets enough that banks lend them money to pay the bills.

What’s more interesting is that because of this accounting change and Geithner’s plan, economists and analysts out there have done some groundwork to see what kind of an impact this will have on balance sheets. Paul Kedrosky points out that maybe this mark-to-market thing is blown out of proportion – GE only has 2% of its assets currently being marked-to-market. But that 2% could shoot up to 20% if GE “feels” like its toxic assets are being unfairly valued by the market. We will only know the true impact of this revised accounting policy once companies revalue their balance sheets using the new subjective rule. Who knows, maybe GE will use “sentimental value” instead of market value, which should yield a better result.

A national accounting standard’s board should never react this way. Accounting, by definition, is the recording of financial transactions. It is a record of what happened. Complex financial instruments make accounting challenging, but adopting new rules on-the-fly to accommodate private interests make accounting useless.

Accounting should always strive to implement and cling to rules that encourage and achieve objectivity. A market transaction is an objective piece of information. It’s an observable benchmark that the world can see. A buyer and seller have inherent biases, but when the two are able to shake hands – that represents a true market value of the asset in question.

This accounting rule change has nothing to do with accounting. In fact, this rule change will lead to a misrepresentation of financial transactions. Maybe stocks will soar because of improved first quarter earnings as a byproduct of this change? Maybe the next move is for Wall Street to strong-arm lenders, accusing them of not lending even though everyone’s balance sheets are clearly healthy again? All of this is irrelevant, though. The most damning result will be that Financial Accounting Standards Board lost its integrity by implementing this change.

  1. Umar, I think your post raises some real issues here:1) If no one wants to buy your assets, then they are theoretically worthless. To cling on to some notion that they have some value is unrealistic.2) If you accept the banks’ argument that such a market is unnatural and therefore prices not representative, then can we not flip that argument on its head and say that the previously inflated prices were unrealistic too as they were part of a bubble. Therefore, those profits/gains previously distributed to shareholders should be clawed back.3) The FASB just caved in to Congress and didn’t follow due process by issuing a consultation paper, asking for comments, etc. Even the FT quoted the IASB as saying this (though to be fair, the IASB caved in to pressure on M2M from the EU).4) If everyone is going to goose up their earnings, whom do we actually believe. This will prolong the agony and uncertainty in the market as investors still won’t know the true extent of losses. Hence, we won’t hit that ever-elusive bottom for the recovery to start.All in all, a disappointing situation.CheersJohn K,London, UK

  2. I love your entire comment, John. It fittingly addresses and extends the areas I didn’t get to. Point #3 in particular is troubling to me, personally. By circumventing due process, it really brings into question FASB and its integrity. The thing is, FASB has helped to shape International Accounting standards – out of everyone involved, they have had by far the most influence. Increasingly people want to move to a unified world accounting standard. But watching them cave I have to wonder how much Wall Street lobbying is embedded in the rules in the first place. I’ve never liked US “Rules-based” accounting approach – for example, when Enron accountants manipulated the consolidation rules (creating special purpose vehicles that were barely under the threshold for consolidation, then subsequently hiding losses in those special purpose entities), I immediately thought to myself what a stupid rule that is. In Canada, and I believe in the UK as well, they tend to avoid giving accountants precise numbers and rules, and basically just give us a vague impression of what the rule is, and use words like, “reasonable” and “substantial,” where us accountants are left in charge of doing the right thing. As a student it was comical to me watching the US try and slap additional rules on top of the original ones that basically prohibited the extremely specific actions that Enron had committed. With the rules approach you have to keep adding rules. But now that I’m all grown up it’s disturbing. They can’t ever fix anything. They make a rule, then all of Wall Street gets together and figures out how to get around it. It’s a game. I watch hedge funds do it all the time with not just accounting rules, but new tax and deferral laws as well. I understand why it’s a rules based approach in the US. Professional Accountants don’t want to be caught dead in a courtroom trying to justify that what they did was “reasonable” or “fair,” they need recourse to say – look, I followed the rule. There’s the rule and I followed it. America is lawsuits waiting to happen. But at the same time it’s so tiring watching them try to create new rules, thinking it will somehow fix the problem.

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