Fair-value Accounting: A Better Reflection of Reality
Fair-value Accounting: A Better Reflection of Reality
By Lisa Koonce, Deloitte & Touche Professor of Accounting
Lately, much discussion has centered around the underlying causes of the financial crisis, and some have suggested that current accounting rules must shoulder some of the blame. Specifically targeted by critics is the focus by the Financial Accounting Standards Board (FASB), the accounting standard-setters in the United States, on fair-value accounting for American firms.
As an accountant who teaches fair-value accounting, I would like to address the issue. Fair-value accounting prices an asset based on its current value. So, for example, if my stock investment, purchased for $1,000, falls in value to $400, then fair-value accounting would show that investment on my financial statements at $400, not the original cost of $1,000.
Those who contend fair-value accounting exacerbated the financial crisis argue that it brought turbulence to the financial system because companies were forced to take billions in write-downs on their balance sheets, as housing prices fell and mortgage-backed securities crashed. These reduced valuations caused financial institutions to look less solid to bank regulators. It was argued, by some, that if banks did not have to follow fair-value accounting (and thus avoid those write-downs), then this crisis would have been averted.
However, this is simply a case of blaming the messenger. Fair-value accounting is not the cause of the current crisis. Rather, it communicated the effects of such bad decisions as granting subprime loans and writing credit default swaps. Even with the difficult issues surrounding measuring the fair value of loans and investments in an illiquid market, as we have seen recently, fair-value accounting only brings transparency to the market. The alternative, keeping those loans on the books at their original amounts, is akin to ignoring reality.
This is an excerpt from the article “Chaos Theory,” which originally appeared in the Fall/Winter 2008 issue of Texas, the McCombs School of Business magazine. Read the first part in the series, David Spence's "The Strange Politics of the Financial Bailout," here. Comments? Email the editor.
Comments
#1 As you stated there are
As you stated there are several reasons why the housing market has changed. But Accounting (FASB) should not be adding to the problems.
For Example: Many people bought their homes 5 years ago and they have increased in value even with the current down turn in the economy. Many people made large down payments on homes thereby making the outstanding loan balance way below current market value. Has does FASB account for that?
When homes were appreciating in value over the past years, Accounting was the first ones to say we can not allow a write up of value for the banks because that violates our Rule of Conserativism. But let the home lose market value and we will require a write down.
Can the banks offset the write down for those loans which increased in value? Or do they only address the write downs?
If you assume Financial Reporting is all about disclosure for Investors and Lenders then you must reconize that a disclosure which requires a write down is not the same as a transaction(an actual foreclosurer).
If accounting required a disclosure in the foot notes reconizing the net exposure(undermarket - overmarket) of the banks housing values then the following would have happened.
1.) The invester would have a clear vision of the current situation for decision making by reconizing the bank would be increasing their reserve for bad debt for those loans in actual trouble(near Foreclosurer).
2.) The Banks would only write down the assets that are actually forclosed on and only for the net(Sold Amount- Loan Balance) when it happens(Transaction occurs) above the Bad Debt Reserves.
3.) Accounting could then audit a real number(transaction) instead of a maybe. Reality versus Science.
Mark to Market Accounting sounds good but should be revisited in methodology and never reflected in a Balance Sheet or P&L unless a transaction occurs.
Foot Notes don't drive Entities into bankruptcy. But they alert investors to changing conditions so they can make informed decisions.
There is nothing wrong with being a messanger, but the message should be clearly understood in content and expression. Foot Note vs Writeoff.
I think we have gone from reality to confusion in the interest of thinking we are making it more transparent for the Investor/Lenders. Clear as mud.
#2 I agree. Showing $1000 on
I agree. Showing $1000 on the books for an asset that is currenlty only worth $400 will make the company appear better off than it really is. That only confuses investors more and makes it more difficult to really value a company. I think the old saying: "If something appears to be too good to be true, it probably is." That about sums up the huge profits companies have made off the subprime loans. It's amazing how greed can cloud even the greatest minds and prevent them from seeing the cliff they're heading towards.
#3 Wayne, The reason that you
Wayne,
The reason that you can't "mark up" an asset is because, if you could, there would be a perverse incentive to do so. Managers would inflate the value of their assets and this would severely impair transparency in financial reporting. On the other hand, there is no incentive to "mark down" an asset.
#4 Frank, I think you are
Frank,
I think you are telling me that Managers are responsible for writing down an asset based on the Market, but they can not be trusted to properly write up an asset because that would inpair transparency. You have to decide first that a Manager is trustworthy or not.
I think you are supporting my comclusion that they need to disclose their current financial and business condition. You just don't trust them to look at the real market conditions except for writing down.
However, my main point is that an investor is interested in the Balance Sheet and Income Statement reflecting "transactions" (real events)and all other possibilities of market changes are to be calculated as an exposure(net) and reflected in the foot Notes.
#5 Jason Mendelson recently
Jason Mendelson recently wrote an interesting piece on this issue from the viewpoint of a venture capitalist.
He makes some good points, in my opinion. The article can be found here: http://venturebeat.com/2009/01/15/why-fas-157-is-stupid/
#6 I agree with professor
I agree with professor Koonce. Abandoning mark-to-market rule would allow corporations to lie legally to the investing public and other interested parties. Markdowns are required to reflect reality, especially for financial institutions and insurance companies holding risky financial assets. Lets not fool ourselves that the managers will do honest reporting, if left unchecked. Additionally, even with the best accounting standards, some vital ratios should be looked at very closely by the investor. One such measure of a company's worth is Book Value. It can be highly misleading. Penn Central had a stated book value of more than $60 when it went bankrupt.
Mark-up of assets should be allowed in cases where, for example, a plant was built 20 years ago, and its replacement cost has now risen substantially. But in case of financial assets, it is a complete no no.
#7 My opinion the SEC/FASB 157
My opinion the SEC/FASB 157 is not a part of the solution but a part of the problem.
Here's another article which drives home the point.
Don’t Nationalize; Suspend Mark-to-Market
We have been accused of beating a dead horse when it comes to our support for either suspension of, or targeted relief from, market-to-market accounting.
And we suppose after writing thousands of words, producing videos and giving speeches about the issue, some might be tempted to let it go. But, we can’t do that, especially when the government continues to spend trillions of dollars and is coming very close to bank nationalization.
This is a real shame. Suspending mark-to-market accounting could fix major problems at no cost. Unfortunately, many people dismiss this issue without really understanding its impact on the economy.
The history seems clear. Mark-to-market accounting existed in the Great Depression and according to Milton Friedman, who wrote about it just 30 years after the fact, it was responsible for the failure of many banks.
Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But, when FASB 157 went into effect in 2007, reintroducing mark-to-market accounting, look what happened.
Two things are absolutely essential when fixing financial market problems – Time and Growth. Time to work things out and growth to make working those things out easier. Mark-to-market accounting takes both of these away.
Because these accounting rules force banks to write-off losses before they even happen, we lose time. This happens because markets are forward looking. For example, the price of many securitized mortgage pools is well below their value based on cash flows. In other words, the market is pricing in more losses than have actually, or may ever, occur. The accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans.
And this affects growth. By wiping out capital, fair value accounting rules undermine the banking system, increase the odds of asset fire sales and make markets even less liquid. As this happened in 2008, investment banks failed and the government proposed bailouts. This drove prices down even further, which hurt the economy. And now as growth suffers, bad loans multiply. It’s a vicious downward spiral.
In the 1980s and 1990s, there were at least as many, and probably more, bad loans in the banking system as a share of the economy. The difference was that there was no mark-to-market accounting. This gave banks time to work through the problems. At the same time, the US cut marginal tax rates and raised interest rates, which helped lift economic growth. Time and growth allowed those major banking problems to be absorbed (even though roughly 3000 banks failed); without creating an economic catastrophe.
In Japan, during the 1990s, the government allowed banks to operate without ever even recognizing bad loans, which certainly bought time. However, Japan increased taxes, which undermined growth, creating an economic catastrophe. The real problem with Japan was not zombie banks, it was that there was no growth. After all, foreign banks were allowed to lend in Japan, but stayed away because the economy was not vibrant.
Suspending mark-to-market accounting is a cost free way to buy time. It does not allow banks to sweep bad loans under the rug. Bad loans are still bad loans and banks cannot hide from them. Not suspending it, while at the same time interfering in the economy with massive stimulus bills and bank nationalization, is a recipe to undermine both time and growth and therefore hurt the economy even more.
Brian S. Wesbury - Chief Economist
Robert Stein, CFA - Senior Economist
Approved for Public Use
#8 The problem isn't the theory
The problem isn't the theory behind mark-to-market accounting. The real problem is how to value assets when there is not market for them.
The prime example is mortgage-backed securities. Because there is no active market for these securities (market illiquidity), there is a large difference between the supposed "fair" value and the economic value imbedded in these investments. One only has to look at Bank's SEC filings to see that the difference between the actual credit losses and the mark-to-market write-downs is about 200-to-1.
This is a prime example of how mark-to-market accounting and the current other-than-temporary impairment accounting rules are destroying capital. Does it make sense to wipe out $200 million of capital because the bank may recognize $1 million of credit losses?
#9 Dear, I do think the best
Dear,
I do think the best answer is the rule of game , i means the international regulation for fairly and true international regulation.e.g. financial instrument should be the same where , how come option Euro and America....
1+1=2 any way