The Accounting Onion

Ten Arguments Against Mark-to-Market for Loans – and 10 Reasons Why They're Wrong (Part 1 of 2)

In my previous post, I argued that the FASB should require accounting for investments in loans at inflation-adjusted replacement cost.  I have not been flooded with reactions from readers, but I did ignite a lively discussion on the AECM listserv, composed mainly of academics, and which included a pretty comprehensive analysis from Emeritus Professor Bob Jensen of Trinity University. It's hard to say how most of the 700-odd members felt, but I did receive some hard jabs.  That indicates to me that there are some legitimate and broad concerns -- as opposed to merely selfish preferences of big money special interests.   

In this post, I have taken their comments (mostly those of Bob Jensen, but there were others who contributed their own, thoughtful two cents) to synthesize ten comments that I can respond to in an organized fashion.  Well, there are actually two posts, because the whole enchilada is just too much too swallow in one gulp without putting everyone to sleep.  I'll cover five issues today, and five tomorrow. There will shortly follow another post in which I will present a T-account derivation of the financial statements I provided, accompanied by calculational notes.

Why have I decided to make such a big deal out of this? I predict this topic will be debated as vigorously by capital market participants in the coming year as healthcare is being debated by the general public. Also, just as with the healthcare debate, there will be spillover to other issues: such as convergence with IFRS and adoption; measurement of all liabilities; measurement of real assets; and most important, the objectives of financial reporting. Thus, reasonable professionals, academics and students will probably have to do a lot of thinking to distill all the rhetoric and to feel comfortable with their positions on the issues.

As to my own views, it is no secret that am in favor of comprehensive inflation-adjusted replacement cost accounting.  Here’s my fantasy:  put me in a room for a year and pay me my consulting rates.  When the year is up, I will emerge with a set of comprehensive accounting standards based on constant-dollar replacement costs that will cover everything that GAAP now covers—in about 100 pages.  The basis for conclusions might take 50 more, and worked out application examples might require another 100.  Not everybody will like them, but everybody will come to understand them.  After that, I’ll re-write Article 2 of Regulation S-X to specify the roles of auditors and other experts in SEC-filed financial statements.

But getting back to reality and the scope of this post, I am going to limit the scope to debt instruments and liabilities.  I am also going to ignore the effects that changes in financial reporting per se have on regulatory capital, instead assuming that regulators will develop metrics of capital adequacy that are independent of changes in accounting rules and policies.  Indeed, there are indications that this may finally be happening.

The First Five Arguments Against MTM for Loans -- and Why I Think They are Wrong

1.  Some argue that HTM fair value adjustments reflect opportunity gains and losses when evaluating management. But these opportunity gains and losses may be so inaccurate that they remain in the realm of total fiction. [The commenter, Bob Jensen, considers "fiction" in this context to be "something that is either intentionally or accidentally reported as fact when in reality it is entirely made up out of thin air and does not relate to anything in reality."]

We should not allow fiction that we are 99.999999% certain is fiction. Keep in mind that all the fair value ups and downs of earnings totally wash out over the lifetime of an HTM security. Interim value changes are pure fiction, especially under IFRS where the penalties are too severe to turn fiction into cash.

Sometimes in accounting, we have to choose among the lesser of two evils.  As I have written about in a previous post, until FAS 106 was promulgated in 1990, it would be fair to state that a more insidious "fiction" had been fed to investors: that retiree health care cost liabilities were zero, when it was far more likely that the amount was closer to a trillion dollars – plus or minus a few hundred million.  Indeed, the chicken salad accounting (so-called "pay-as-you-go") prior to FAS 106, which inappropriately delayed recognition of those costs until they were actually paid in cash, is in large part responsible for the demise of GM, just to name one of many casualties.  Thus, even when economic values are measured with huge error, unbiased estimates of changes in value are far better than presentations that pretend that such changes are zero.  Despite its flaws, I'm quite confident that most would aver that FAS 106 was a much-needed improvement to financial reporting.  So, if one is against reporting "fiction" as a matter of principle, how can one justify "fiction" in measuring retiree health care costs, but not for loans? 

One might argue that narrative disclosures of changes in market conditions and other factors are preferable to imprecise measurement, but history has proven conclusively that in both the notes to the financial statements and MD&A, little more is provided than boilerplate.  As Pat Walters (Fordham) indicated on the AECM listserv, it would be preferable to measure economic values on the financial statements, and disclose contractual amounts in the notes. 

I also wonder whether those who support HTM because of measurement limitations, also support HTM for investments in bonds with readily determinable market values?   In fact, the two FASB members who objected to HTM accounting when it was promulgated as an allowed alternative were Bob Swieringa and Clarence Sampson.  Swieringa is an academic (whom I'm proud to say was one of my teachers), and Sampson is a former SEC chief accountant who worked at the SEC for 28 years.  The other five came from the Big Six and/or industry, and would have been seen by Lawrence Revsine through his "selective measurement hypothesis" as having been "captured" by the regulatees. 

Speaking of Clarence Sampson, in an interview sponsored by the SEC Historical Society, he provided a gem of a story that could foreshadow the kind of 'feedback' (to put it mildly) the FASB will get to its forthcoming exposure draft.  Sampson was asked about the SEC's decades-long battle to improve the accounting for financial instruments by banks:

"[Accounting by banks] … was by today's standards horrendous back in the '60s … bad debts were not shown as an expense; they determined income before they took out the bad debt …[W]hen the Commission considered this question, the Chairman of the Federal Reserve came over and protested, dragging his feet all the way …" [italics supplied]

I am supposing that the banking industry's arguments against bad debt expense reporting was something like, "We should not allow fiction that we are 99.999999% certain is fiction."  If that kind of reasoning didn't wash then, it shouldn't now, which incidentally leads us to dealing with the second issue.

2.  Suppose a firm borrows $100 million by selling 10-year bonds at 5% with the holding that debt to maturity. Letting earnings fluctuate for 40 quarters for fictional gains and losses of value changes on those bonds is more misleading than helpful investors in my viewpoint. It may be especially fiction if there are cost-profit-volume considerations. Just because a few investors in those bonds are willing to sell at current market (thereby making a market) does not mean that all investors are willing to sell at current market rates. There are issues of blockage costs of trying to buy all the bonds back versus buying only $1 million of those bonds back.

It is indeed true that the earnings fluctuations will wash out IF there is no inflation, AND IF the loan is paid in full.   The problem, though, is that inflation is ALWAYS with us; my example conclusively demonstrates that, when properly measured, the holding gains and losses on debt don't wash out, even when the bond is repaid in full.  The reason for this is that inflation, even when it is low, can have a significant effect on economic earnings.  Thus, it's a pretty safe bet that, if inflation were properly taken into account, managers' preferences for long-term debt as opposed to equity financing would shift towards equity.  And as another consequence of the proper accounting, it would become more common for regulated financial institutions to hedge their exposures to unexpected inflation.  Currently, accounting standards discourage that, even though it may be in everyone's interests to do so.

But, since the FASB is not proposing to measure the changes to loan valuations at their inflation adjusted amounts, I support their proposal to relegate the fluctuations in fair value to other comprehensive income (OCI), and to exclude them from the EPS calculation.  That's because I'm fairly indifferent as to income statement presentation, especially with the prospect that XBRL will allow investors to tailor income statement presentation to their needs.

As to the problems attendant with the valuation of one's own debt, I believe in symmetrical measurement of financial transactions, i.e., transactions that only transfer wealth as opposed to create it (see this post).  This means that a debtor should report its obligation at the lender's replacement cost of its investment (except that the debtor would not include the transaction costs that the investor would incur to replace the investment).  Among the advantages of relative simplicity and clarity of principle, blockage factors would come into play only if there were investors holding relatively large blocks.

3.    But even if we can accurately measure the value of the $100 million in debt, value to financial reporting is not served by booking repeated gains and losses that automatically wash out over the year life of the bonds. This is especially the case in IFRS where severe penalties are incurred for firms that the IASB imposes on companies that renege on their held-to-maturity pledges. How can you adjust fair market value of HTM securities for the penalty clauses of the IASB for reneging on HTM pledges?

Refer to my answer to 2, above, regarding the washing out of gains and losses when measured in nominal dollars, i.e., when adding apples and oranges. 

As to the IFRS "penalties," that comment refers to a provision in IAS 39 (para. 46b) in which a company must essentially cease use of HTM accounting for the current and subsequent two years if they liquidate a bond investment before maturity.  Actually, U.S. GAAP is not significantly different; the two-year penalty provision has been a long-established policy of the SEC staff since virtually the effectiveness of SFAS 115.  The IASC, probably controversially, inserted it in IAS 39 as part of their hasty scheme to appease the SEC and be able to state that it completed  the momentous, five-year "core standards" project one year early (1999).  What a joke. 

As to whether there is a "severe penalty" for breaking the HTM "pledge," absent any regulatory effects that are neither the fault or responsibility of accounting standards setters, I fail to see how changing the location in the accounts of one's debits and credits penalizes shareholders in any real sense.  Call me old fashioned, but cosmetic accounting changes don't affect future cash flows unless they are factored into management's decision making processes.  For example, a change in accounting could affect that portion of management's compensation which is earnings-based, and management could react accordingly; but if the BOD thinks that would be a bad thing, they could certainly make the necessary adjustments.

4.    We might be able to estimate a reliable change in value of a HTM-designated asset or liability, but reneging on the HTM pledge will impact a raft of other past and future contracts that are almost impossible to factor into the damage caused by reneging on a single HTM pledge.

If we require current-cost accounting in any form, then HTM goes away; and absent HTM, I can't conceive of any reason why management would pledge to hold a security to maturity without adequate compensation for giving up their options.  So, let's say that management does make that pledge and debt securities must be valued at replacement cost.  Valuing the security by the replacement cost of the security as an asset to investors should handle this problem.

5.    Debtors could book debt at current call back values, but these call back values often have penalty clauses that make them poor surrogates of current value, especially when penalties are severe.

I don't see this to be a significant factor if, as I stated earlier, the measurement of debt is its replacement cost to the holder. 

That's all for now.  My next post will deal with issues related to derivatives, hedge accounting, what agency theory has to say about the controversy, and complex executory contracts.  I'll give you the issues I'll be responding to, and you can start thinking about your own responses now!

 

6.    There are also hedge accounting considerations.  Paragraph 79 of IAS 39 does not allow interest rate risk hedge accounting for HTM securities. Paragraph 21(d) of FAS 133 similarly precludes hedge accounting treatment for interest rate risk and FX risk, although credit default hedges are permitted. Available-for-sale securities can get hedge accounting relief.  Mark-to-market proponents could argue that elimination of HTM designations and valuation of all financial securities at fair value eliminates some of the complexity of having hedge accounting available for AFS securities and unavailable for HTM securities. However, in my viewpoint having hedge accounting for securities that the company pledges will truly be held to maturity causes more problems by having both hedge accounting and fair value adjustments on these securities set in stone for the duration of their life.

7.    The argument for valuing the right side of a balance sheet on the basis of CLAIMS is grounded in agency theory.  Trying to parcel out, in real time, the shift in relative economic fortunes is a pickle of a problem. 

8.    We cannot report economic earnings to a point where fair value adjustments have errors of magnitude that destroy credibility in the reporting of earnings or assets or liabilities or equity. This is one of the reasons we do not report economic earnings from long-term purchase contracts such as the Dow Jones contract to buy newsprint (paper) from St Regis paper for 50 years. Sure we can build a model to estimate the 2009 $1.3 billion change in net present value over 43 more years of purchasing paper, but no sensible investor would have any faith whatsoever in that $1.3 billion number because of all the contingencies affecting both Dow Jones and St Regis over the next 43 years, including the possibility that newspapers will cease publishing hard copy in the next decade.

9.    Continuing the previous example, courts of law most likely would not pay any attention to the net present value of paper from trees that have not yet been planted.  One of the reasons we do not book long term purchase contracts is that, when broken, the damage settlements are often a miniscule fraction of net present value estimates of full-term contracts.

10.    Mark-to-market accounting makes sense only to a point where the reported numbers have some relevance in estimating future returns and risks. However, when carried to extremes of sheer fantasy and valuation models with enormous missing variables, then we are no longer providing a service to investors. The problem with measuring assets and liabilities at replacement cost (or fair value) is that it is not the goal. If we report earnings with a total loss of credibility, the profession of accounting will become a laughing stock alongside the profession of astrology. Even economists (gasp) will laugh at us. Clients will no longer want to pay our fees --- that’s ultimate loss.

 

FAS 141(R): Turning Toxic Loans into Star Performers*

From a MoneyNews.com story published this Wednesday headlined "Banks Stand to Reap Billions from Purchased Bad Loans," came an account of a jaw-dropping transaction. It was spawned by FAS 141(R), the latest and greatest standard on accounting for business combinations:

"When JPMorgan bought WaMu out of receivership last September, it used the purchase accounting rule [FAS 141(R)] to record impaired loans at fair value, marking down 118.2 billion of assets by 25 percent.

Now, JPMorgan says its first-quarter gains from the WaMu loans resulted in $1.26 billion in interest income and left the bank within an accretable-yield balance that could result in additional income of $29.1 billion."

Business combination accounting has forever been fertile ground for earnings and balance sheet management for one simple reason: the opportunity to tweak the amounts reported for the assets acquired and liabilities assumed, with the ultimate objective of brightening post-acquisition earnings reports. But, as tiresome as that old game might be, the kind of maneuver that JPMorgan's management has engineered is a novel twist on an old loophole that had once been closed pretty tightly by the SEC.

The Closed Loophole that Would Be Re-Opened by the FASB

Once the "pooling of interests" method of business combination accounting of APB 16 was abolished with the advent of FAS 141 (not to be confused with FAS 141(R)), the most basic surviving principle of business combination accounting became thus: the acquisition of a business should always be reflected on the financial statements of the acquiror by assigning a new carrying amount to each of the acquired company's assets and liabilities. This new carrying amount would be updated, based on current assumptions and estimates regarding the future role of the acquired assets and liabilities in the combined entity. The implementation of this principle had long been known as the "purchase accounting" method for business combinations.

With certain important exceptions, SFAS 141 mandated that new carrying amounts for assets acquired in a business combinations would be based on their fair values. The exception that is germane to the JPMorgan story pertains to loans (i.e., trade receivables, interest-bearing loans and marketable debt securities classified as held-to-maturity). The measurement bases for these items were carried forward from APB 16's version of the purchase accounting method: a gross amount reduced by an appropriate allowance for uncollectible accounts. This exception to loan measurement was important, because it also meant that a 1986 SEC staff position would still be applicable to purchase accounting.

At that time, the SEC saw fit to put a stop to unwarranted increases in the allowance for loan losses as part of the business combination transaction. Increases to loan loss allowances would mathematically transfer future loan losses to goodwill, where they would be deferred indefinitely, with the effect of reporting inflated earnings in future periods as the loans were eventually settled for more than their understated carrying amounts. Staff Accounting Bulletin 61 (Topic 2-A(5)) states that the SEC would not permit any adjustments of the acquiree's estimate of loan loss reserves, unless the acquiror's plans for ultimate recovery of the loans were demonstrably different from the plans that had served as the basis for the acquiree's estimates of the loss reserves.

FASB Amnesia?

FAS 141(R) did away with the "purchase method" and established the "acquisition method" of accounting for business combinations. It apparently did so out of a belief that measurements of assets and liabilities that are based on the most current information available are usually, if not always, preferable to valuations based on less-current information. The JPMorgan case glaringly points to a significant flaw in that belief: inconsistent application of fair value could be more harmful than consistent application of a less desirable attribute. As to the case at hand:

• WaMu, as is quite common, accounted for its loans based on a held-to-maturity model. That is, except for recognizing declines in creditworthiness, the loan carrying amount is based on the original contractual terms; interest is accrued by multiplying the net carrying amount by the yield to maturity as of the date the loan was originated/acquired.

• Even though the market value of these loans had declined significantly as they turned toxic, WaMu apparently was not required to record losses to bring the loans down to their fair values.

• JPMorgan, when acquiring WaMu, was required by FAS 141(R) to mark the loans to market. Subsequent accounting by JPMorgan will continue the WaMu the held-to-maturity model.

It would be a pretty safe bet that JPMorgan was very 'conservative' in their estimates of fair value for the loans; that's because the lower the fair value, the higher the yield to maturity, and the higher the amount of reported future earnings. Of course, there are some limits to JPMorgan's estimate of fair value: auditor pushback, SEC review, increased risk of goodwill impairment charges, and capital adequacy regulations. But, at least in this case, it is possible to become rich without being greedy.

Where is the SEC!?

Maybe there has been more coverage of this issue, but I haven't seen it; kudos to its author, Julie Crawshaw of Newsmax. If we are concerned that bank executives are being overcompensated, especially on the taxpayers' dime, here is a prime example of where insufficient oversight has spawned a new source of moral hazard.

For starters, the SEC should put a stop to this obvious and blatant abuse, immediately. They should issue another SAB, carving out the offending provision of FAS 141(R) and restoring the long-established and functioning status quo. Every company that benefitted from the ill-conceived accounting rule should be forced to retroactively restate their earnings – especially any financial institution on the government dole.

Perhaps the lack of permanent leadership in the Commission's Office of the Chief Accountant is contributing to a lack of attention to this obvious problem, but it is in no way an excuse. Also, this is a problem created by the FASB. Let's be charitable and call it an unintended consequence, but whatever the cause, the FASB should move to fix it forthwith. I'm suggesting that the SEC should act first, solely because they have the demonstrated capability of being able to move the fastest. That's because a SAB doesn't have to be exposed for comment before it can be issued.

But, lacking any actions by either the FASB or SEC to put the cat back in the bag, auditors (perhaps via the PCAOB), and boards should be put on notice of a new potential scheme to inflate executive compensation in the absence of actual value creation for stakeholders. If a single dime of executive compensation comes out of accreted excess earnings from these business combination games, I hope that private securities lawyers will round up the proxies and the lawsuits, settling for nothing less than "a pound of flesh."

A larger lesson is important to briefly discuss in order to understand how this kind of loophole can occur: in accounting for financial assets, the only workable system is comprehensive mark-to-market, all of the time. The current situation is a consequence (intended or otherwise) of the piecemeal approach pursued by the FASB (and IASB) towards fair value accounting.

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*Note:  I made a technical correction to this post, that you can view here.

More Reasons to Excise Contingent Liabilities from Balance Sheets

In responding to my previous post on contingent liabilities, a few of my kind and sensitive readers raised the following points:

• Why should there be a difference in the accounting for a law requiring sellers to compensate their customers for defective products, and an express warranty to the exact same effect? (Discussed below.)

• Are deferred taxes arising from, say, a higher carrying amount for an asset relative to its tax basis a liability? Why do we have deferred tax accounting in the first place? (Discussed below.)

• I incorrectly characterized the provisions of IFRS 3(R) pertaining to contingent liabilities assumed in a business combination. (I made the correction.)

A Legal Requirement versus an Express Warranty

I did not explain myself fully on this point. The power of a government to change its laws creates a possibility that an obligation could be arbitrarily and capriciously eliminated, while stiffing the 'receivable' holder in the process. Moreover, the same merely legal obligation (in the absence of a contractual warranty) could be cancelled by the obligor by dissolving itself. 

Are these distinctions between a legal obligation and an express warranty too fine, glib, or heaven forfend, theoretical? Perhaps I could be guilty of mere post hoc rationalization to support my subjective point of view: to wit, the futility of harboring any hope that accounting standards can be effectively crafted to result in reliable and consistent measures of contingent liabilities?  But, whatever my conscious or unconscious motivations, the point that all must concede is the impossibility of enunciating an accounting policy that will result in the recognition of all of the liabilities of an entity. So, if you have to draw a line somewhere, I am humbly suggesting where that line can be drawn, in a principled manner, no less. 

Deferred Taxes: My Conspiracy Theory

Whatever you may think about whether a deferred tax liability is a legitimate liability, you should know of the conspiracy between issuers and auditors that gave birth to the ersatz accounting theory of "interperiod tax allocation. It is the curtain behind which corporate America tries to hide the reality of just how little in the way of taxes a company might be paying in to government coffers.  A systematic earnings reduction in the way of an additional tax expense accrual can be a bitter pill to swallow, but so long as everyone has to take the same proportional hit, nobody actually gets hurt.

The political pressure to modify corporate tax laws in the name of some congress person's pet cause/peeve resulted in a tax code replete with accelerations of deductions, deferrals of payments, exemptions, shelters, loopholes, etc. Post WW II, the corporate tax code quickly got to the point that the actual taxes paid by corporations could be miniscule relative to reported GAAP net income before taxes. The public rightly asked why corporations' 'effective' tax rates were so much lower than the advertised 'statutory' rate. In order to evade directly answering that question, deferred tax accounting was invented to make it appear that corporations were paying their 'fair share' – or at minimum, make it appear that corporations would eventually have to pay their fair share.

Which brings us to the question of whether a "deferred tax liability" is really a liability? Once again, and for the same reasons I gave above, my answer is "no." If a government wants to reduce its tax rate, for whatever reason, the liability goes away. And, companies can control their "deferred taxes" as well.  Take, for example, the deferred tax liabilities of a company in dire financial straits, like General Motors. After bondholders are paid ten cents on the dollar in some sort of re-organization, and the deferred tax liabilities on the balance sheet melts away, can the government say it was stiffed? No way.

Another Reason to Exclude Contingent Liabilities

If the FASB and IASB are going to keep tweaking their respective contingent liability standards, and they envision a day when balance sheets will be stated at full fair value, they will eventually have to face up to the fact that there is no reasonable way to measure the fair value of a contingent liability that cannot be transferred. The only approach that comports with reality is to measure the amount it would cost the counterparty to replace (as opposed to transfer) a pattern of cash flows identical to its non-contractual, contingent 'receivable.' But, even that can be so problematic and subjective that I say, 'fuggedaboutit.'

With Niemeier as Chief Accountant, the Yoke of IFRS Will be Lifted

I recently found this quote from H. G. Wells, the English novelist and historian, in the introduction to the "Mike Gravel edition" of the Pentagon Papers:

"The true strength of rules and empires lies not in armies or emotion, but in the belief of men that they are inflexibly open and truthful and legal. As soon as a government departs from that standard, it ceases to be anything more than 'the gang in possession,' and its days are numbered."* [italics supplied]

I wasn't reading about the Pentagon Papers in search of a financial reporting parable; but alas, such is my wont in this tide of times. Or, perhaps it was because Bloomberg News set my heart aflutter when it reported that an unnamed source disclosed that Mary Schapiro is considering making Charles Niemeier the SEC's Chief Accountant. Follow-on coverage is available from the CPA Blog.

Niemeier was a charter member of the PCAOB, and before that he was Director of the SEC's Division of Enforcement. He is a CPA who has practiced both securities law and accounting.  In addition to his obvious qualifications-- well-educated, intelligent and experienced -- there are three other things I like about Niemeier. First, he rehabilitated "maverick" for being the only public official with the courage and principles to speak out against the Cox party line on IFRS adoption and PCAOB inspection (or lack thereof) of foreign firms. Niemeier must have known that his open defiance would ultimately lead to the loss of his seat on the PCAOB, worth over $500K per year. Even for a Charles Niemeier, it is not a trivial matter to replace that kind of money and status.

Second, Niemeier may be one of the few qualified individuals who does not have strong ties to the Big Four. Mind you, off the top of my head I can think of at least three former Big Four partners who became Chief Accountant, and each of whom I respected and admired for their commitment to investor protection. Notwithstanding these talented and principled individuals, I don't think it would be advisable or appropriate to pick another of from that background given the current environment. The pressures on the audit industry, and its own lobbying efforts, are too intense. Mary Schapiro could not justify taking the risk that a recent alumnus of the Big Four, Five, Six, etc. would yield to the temptation to carry water for old buddies and erstwhile partners. It may not even be possible for such an individual to be mentally re-programmed from auditor/preparer advocate to investor advocate. (Apologies to all of my friends who work as auditors, but I can't think of another way to put it.)

Third, I dig what he preaches. Niemeier sees no good reason for the SEC/FASB to punt the authority to set accounting rules to the IASB, other than to feather the beds of executives and auditors. Fair value accounting is a tough issue, but he is not afraid to stand up to those who would compromise truthfulness (notice I don't say "truth") in accounting for the twisted logic that somehow being less than that  helps to make capital markets more stable and secure.

If Schapiro does eventually make Niemeier the Chief Accountant, the likelihood of IFRS adoption, even in the eyes of its most ardent supporters, will have slid from "inevitable" to "over my dead body."  In a much larger sense, we will have an unequivocal signal that the old gang in possession is not being replaced with a new one.  

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*The Pentagon Papers: The Defense Department History of United States Decisionmaking on Vietnam, Senator Mike Gravel Edition, Beacon Press, 1971.

IASB: The Rules of Arithmetic Are Suspended Indefinitely

"The London Symphony played Beethoven last evening, and Beethoven lost." That quotation, which my father attributed to George Bernard Shaw, leapt into my mind as I read Marie Leone's CFO.com report of remarks made by Thomas Jones, vice chairman of the IASB:

"… in general, he [Jones] and other IASB members support fair value accounting for financial instruments, but 'don't believe in fair value for the factory or production machinery.' Jones observed that leaving aside the issue of mark-to-market accounting in an illiquid market, 'I think that fair value does capture reality.' The only thing historical cost captures regarding financial instruments is an 'accurate' but 'meaningless' number, he opined." [italics supplied]

Principles-based accounting didn't just lose, it was assassinated. "O, pardon me, thou bleeding piece of earth, that I am meek and gentle with these butchers!" (The Bard's Mark Antony to Caesar's corpse.)

It appears that Jones' position (and that of the other board members Marie Leone reported him to have spoken for) is that fair value measurements should be restricted to financial instruments that can be sold in a liquid market. If fair value has such limited application, and historic costs are meaningless, then perhaps neither one of these measurement attributes belongs in a principles-based system of financial reporting. Of course, as many of you may realize from reading previous posts, I believe I know which attribute does belong: replacement cost.

Mr. Jones evidently is of the opinion that fair values for "factory or production machinery" yield illusory measures of profitability – and I agree. To make the larger point as simply as possible, let's consider the implication of fair value on inventory. One does not simply make a profit by producing inventory; it has to be sold. That's because real wealth is "command" over goods and services, and no one can be commanded to buy what you produce. Perhaps somebody can be convinced to buy a car from GM (although it appears to be getting harder by the day), but having a car in inventory in no way represents command over anything – except for that car in inventory. (By the way, nobody can be commanded to buy your junk financial instruments from you either.)

The sense of the word "command" in economics is that every owner of an asset has their price; offer a high enough price, and at least in theory, anything that is legally salable is available for sale. That's why replacement cost of all of the assets at one's disposal is the economist's standard choice for measuring wealth.

Replacement cost as the attribute of an asset to measure also resolves both of the problems I have with Jones' positions. First, no number reported for an asset will be "meaningless." Replacement costs of financial instruments and producing assets is the money equivalent of already owning a resource instead of having to expend cash to acquire or produce it.

Second, the problem of illiquid markets for financial instruments goes away. A financial instrument is fundamentally a stream of risky cash flows. It is always possible to estimate how much it would cost to acquire the financial asset, and circumstances will dictate the most reliable method for making that estimate. The illiquid markets caveat is nothing more than code for "I can't find someone to buy my junk asset for the price I want to sell it."

I learned to write my name on my first day of elementary school. On day two, I learned that one plus one only makes two when we add two like things. Does anyone else see a problem with ceding accounting standards to a single group whose putative leadership sees no future for accounting except for one that violates the most basic rule of numbers and logic we all learned by the first grade?

The Credit Default Swap Mess: Did U.S. GAAP Play a Role?

A member of the AECM listserv reported that today's episode of "60 Minutes" explained that a credit default swap (CDS) "was actually an insurance instrument, and perhaps fraudulently sold as [a] financial instrument to avoid insurance regulations and insurance regulators." It is hard for me to challenge that assertion, as I am certainly no expert on insurance regulation, I do know that many financial contracts that meet the definition of a "derivative financial instrument" contains elements of insurance. 

But, even though one can easily point to instances where our financial markets lacked adequate regulation in recent years there is some danger in blaming the lack of regulatory oversight for the entire mess. The regulatory pendulum invariably swings too far back when pushed by politicians seeking a quick fix to the financial malaise of the moment. Therefore, I want to propose yet another accounting fix that might obviate some of the more extreme actions being contemplated—like broadening insurance regulation beyond its historical boundaries, or even scapegoating Wall Street executives (there is already just cause for much abuse of that crowd).

At the outset, I should also state that as is often the case lately, my thoughts in this area were catalyzed by – you guessed it – Jim Noel. He really needs to have a website that I can link to.

Thou Shalt Mark (Some) Derivatives to Market

Statement of Financial Accounting Standards No. 133 requires derivative financial instruments within its scope to be measured at fair value. No exceptions. It sounds like a principled-based standard so long as everyone understands what a "derivative financial instrument" is. In fact, so many things can be seen to be derivatives (insurance contracts not excepted) that FAS 133 could have altered the entire landscape of accounting if the phrase "within its scope" were omitted from the previous sentence.

For example, ordering pizza for delivery has all the economic earmarks of a forward contract. I realize that I'm being a little bit silly here, but I hope you get my point: one of the FASB's objectives in promulgating FAS 133 was to curb abuses from reporting really important zero-value-at-inception financial contracts, like interest rate swaps with notional amounts in the billions of dollars, the same as a pizza delivery order. If the price of pizza changes before delivery takes place, that's not such a big deal unless you're a poor college student (not bad grades, no money … get it?). But if LIBOR declines by 10 basis points, you went from neutral to a big transfer of wealth on a $10 billion swap contract.

CDS's and FAS 133

Among other things, a derivative within the scope of FAS 133 has to have an "underlying" (para. 5a), which is defined in the glossary of the standard as:

"A specified interest rate, security price, commodity price, foreign exchange rate, index of prices or rates, or other variable (including the occurrence or nonoccurrence of a specified event such as a scheduled payment under a contract). An underlying may be a price or rate of an asset or liability but is not the asset or liability itself." [bolded italics supplied]

Can you see that some of these "other variable[s]" may overlap with events that might otherwise be dealt with via insurance? The FASB certainly realized this when they specifically excluded certain types of insurance contracts from FAS 133 (para. 10c). With specific exceptions, however, financial guarantees (think CDS's) are within the scope of FAS 133 if they also meet derivative criteria set forth in paragraphs 5 – 9 of the Standard. I certainly don't want to criticize the FASB on this point, because I think that whether or not you call CDS's insurance or a derivative financial instrument, these are contracts that need to be marked to market. The FASB's intentions were, I believe, well-reasoned, but there is no avoiding rules-based accounting when you have a multi-attribute accounting model.  There is only one way to distinguish between which assets will be marked to market, and which will be valued otherwise: rules.   

Put This in Your Capital Adequacy Pipe and Smoke It!

The point is that even well-intentioned and well-crafted rules can come back to bite you.  One problem is an arcane practice in accounting dubbed "offsetting" by the cognoscenti. It happens all the time, not just involving financial instruments, and it's stealthy: gains and losses on disposals of long-lived assets (offsetting the cost and revenue components); operating lease accounting; pensions. There are all kinds of pronouncements, major and minor, that either explicitly or implicitly bless offsetting, but with derivatives it has come back to bite us real hard. So hard, that I think the practice of offsetting any asset with any liability should be declared streng verboten.

To see why it can be so problematic with derivatives, take a financial institution with $9 billion of liabilities covered by $10 billion of assets. Next, assume that said financial institution enters into a CDS (or any sort of derivative – I don't care) with a notional amount of $10 billion.

FAS 133 would yield a value of zero for this derivative investment at inception because the receivable leg of the 'insurance coverage' (or interest receivable in an interest rate swap) on the $10 billion would be exactly offset by the liability leg: i.e., the 'insurance premium' (or interest payable). Even though we have an accurate report of fair value, we have no idea of the exposure to risk of changes in fair value.  

For purpose of illustration, let's say the present values of those asset and liability legs are both $7 billion.  The balance sheet picture would be altered by reporting $16 billion in liabilities ($9 + $7) covered by only $17 billion in assets ($10 + $7), as opposed to offsetting the two and ending up with zero. You don't need Basel II to figure out what's going on here: FAS 133 does a good job of measuring the value of derivatives, but disclosures notwithstanding, provides nada to help understand the risk of future changes in value. 

Simple Would be Nice for Once

Congress just passed a bailout bill that went from three pages to over four hundred in about of week of deliberations. Requiring the asset and liability sides of derivatives to be separately measured and reported seems like an amazingly simple fix that could simplify regulation of the financial and insurance industries, reduce the need for the disclosures in financial statements written so as to discourage one from reading them, and help investors more easily assess risk.

What I am proposing is certainly not a panacea, because there is still much that is wrong with financial reporting—but do see my earlier post on wiping out securitization accounting (FAS 140). Nevertheless, I'm willing to bet that much of the accounting-driven financial engineering, excess investment and speculation with derivatives that has brought our economy to its current sorry state could be derailed: if we take the simple steps of eliminating offsetting in derivatives reporting, and wiping FAS 140 off the face of the earth.

Fiddling with Fair Value as Rome Burns

If you took a look at the House Bill that went down in flames today, you might have caught Congress fiddling with GAAP as Rome burned. See Section 132 of the bill proposed to empower the SEC to suspend application of FAS 157, Fair Value Measurements at any time, and for any company. Doesn't Congress know that the SEC already has the power to make and break GAAP?

See also Section 133, which directs the SEC to submit a study to Congress on FAS 157 as it applies to financial institutions, and preferably to make FAS 157 and the FASB a scapegoat for bank failures. If Congress were serious about studying accounting's role in how our economy's "fundamentals" have been heading due south, they shouldn't be looking at FAS 157, because it only addresses "how," and not "when" fair value is to be measured. "When" is, of course, the real question, which means that Congress should be questioning instead the accounting standards that the members' banker friends actually do favor: FAS 115 (marketable securities), FAS 140 (securitizations), and FAS 114 (loans). You know, the ones with the loopholes. Such is politics.

The Blog Must Go On

I feel somewhat abashed to be discussing the niceties of financial reporting in the wake of current events, but if Congress can do it, why can't I? My topic for today is to follow up my previous post on current value accounting, discussing whether the current values to be measured should be replacement costs or fair values. Specifically, I want to share with you my reactions to Federal Reserve Chairman Ben Bernanke's view of "hold-to-maturity" versus "market value." Two other comments on my advocating for replacement cost accounting (and a history lesson from Bob Jensen) also got me thinking a little bit more about what I wrote.

First, Bernanke gave congressional testimony arguing that two prices existed for troubled loans: a "hold-to-maturity" price and a current market price. At first blush, this sounds something like the difference between replacement cost and fair value, but it isn't. This is important to me, because I think that some people (for example, see the comment of George Weintraub on my previous post) may erroneously associate replacement cost measurements with 'value in use,' which I believe would be the FASB's nomenclature for what Bernanke has called "held-to-maturity." There can be no question that value in use invariably presents one with a reliability problem due to the subjectivity of estimating future cash flows and discount rates (i.e., 'mark-to-model'), but that is not necessarily the case with replacement costs.

Moreover, I'm not sure that Bernanke, whose intellectual capacity I respect and admire, is making much sense here (and I suspect he knows that). If we are talking exclusively about financial assets and a global marketplace, how could it be that the market price understates the present value of holding a loan until maturity? If the subject were changed to producing or consumption goods, one could expect a difference between value-in-use and value–in-sale. However in the case of financial assets, such a presumption is perhaps a step too far. Teaming up with Treasury Secretary Paulson to sell such a dubious notion to the public may in the long run affect Bernanke's reputation for independence, just as Greenspan's reputation was damaged by his flip-flop on Bush's tax cuts.

Moving on to replacement costs and financial assets, the 'bid-ask' spread captures the difference between replacement cost and fair value. The 'bid' price is fair value, because it is the amount that someone is willing to pay to purchase the asset from you. The "ask" price (a higher price) is the replacement cost, because it is the amount that a market participant who already has the asset is willing to sell it to people who want it. But, even if there is no formal market maker to provide both bid and ask prices, the concept still applies for the purpose of comparing replacement cost and fair value accounting. For example, and moving from financial to real assets (and I owe this one to Bob Jensen), bluebook prices for vehicles are the functional equivalent of average ask prices by used-car dealers.

Second, Jim Noel, my longtime friend and sounding board, expressed his doubts after reading my previous post that replacement costs were an appropriate basis of measurement for bank balance sheets. That's because the single most important question to ask about a bank, as the financial crisis painfully illustrates, is liquidity. Indeed, the strongest argument for fair value is that it is the gold standard for measuring liquidity.

My response to Jim is to revert to core principles (at least mine) of financial reporting: investors primarily seek information about wealth and changes in wealth. In normal circumstances, liquidity is of secondary importance. As a case in point, maximum liquidity leaves one with just cash and no wealth producing assets.

Granted, there are circumstances when liquidity is paramount, but that should not mean that principles-based accounting needs to be either replacement costs all the time, or fair value all the time. For example, when ARB 43 requires a departure from historic cost to measure inventory, the general basis of measurement is replacement cost. However, replacement cost valuations are capped by 'net realizable value' and floored by 'net realizable value less incremental costs to sell.' A second, and more general example, is the required switch to liquidation values when an entity's ability to continue as a going concern becomes doubtful to a sufficient degree.

The Fair Value Debate Needs Some Rules

My general sense is that some order is needed to make sense of the challenge to fair value. Whatever your position is on the issues, I would like to suggest that you think about providing answers to the following three questions—in the order listed:

1. Which assets and liabilities should be measured at current value?
2. Which 'attribute' of an asset or liability should be measured—i.e., replacement cost, fair value, historic cost, present value of future cash flows?
3. What rules would be needed to assure that the attribute chosen is reliably measured?

Which assets and liabilities should be measured at current value -- So much of the balance sheet and earnings volatility that the fair value naysayers are complaining about is brought on by our 'multi-attribute model', where some assets and liabilities are measured in terms of actual past cash outflows and others are measured in terms of estimated future cash inflows. The status quo is simply not stable, so we have to decide whether to move backwards to historic cost or forward to a single set of current values.

Of course, I believe that means we have to finally bring ourselves to measure liabilities as well as assets at their current values. This shouldn't be so hard. A simple economic principle that I pointed out in a previous post is that all of the liabilities of an entity are perforce assets of other entities. If we can measure these financial relationships when they are on the lender's balance sheet at current values, then why in the name of symmetry can't we use that valuation for borrowers? Oy, it makes me crazy.

Which attribute should be measured – Some say fair value, some say present value of future cash flows, some are sticking with historic cost, and I say replacement cost. Whatever your druthers, reported earnings will not pass a reasonableness test until we stop being content with adding apples and oranges on the balance sheet.

How to reliably measure the current value attribute chosen? -- I hope George W. (the Skeptical Texas CPA) and others may now see that the difference between replacement cost and fair value is really not a difference between market quotes and mark-to-model. Rather, it's how best to measure what it is you think ought to be measured. Maybe fair value and replacement cost measurements will require mark-to-model every now and then, but for reasons I pointed out in a previous post, replacement cost measurement will require less of it.

http://cryptome.org/bailout-2.pdf