Accounting Rules Gone Amok - The Unintended Consequences of Mark-to-Market Accounting

What is the purpose of financial accounting? Without looking at any formal definition, I'd say it's something like the following:

To provide investors with a clear and useful picture of a firm's current financial position, as well as how that position has changed from prior periods as an outgrowth of operating performance.

Yes, there is lots of other stuff that is involved but this, IMHO, is the bottom line. New accounting rules governing the marking-to-market of both sides of the balance sheet, and its related impact on income statement reporting, will likely serve to cloud and obfuscate an already complex picture, especially when it comes to financial institutions' accounting disclosures. This was driven home in an article in today's Wall Street Journal titled The Gold at Crunch's End. The title alone is enough to give me pause, but the content is even more damning if one considers the intention of our accounting policy-makers:

While the bond-market mess made the earnings reports for the big investment banks feel like a game of roulette, there was one area where they were almost guaranteed to win: profits generated by the falling value of their own debt.

That allowed the firms to book hundreds of millions of dollars in profit, helping to offset multibillion-dollar charges they had to take on commitments to fund leveraged buyouts.

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The brokers and banks are doing nothing wrong or improper in booking such gains. The accounting rules as they stand allow the practice. But some investors are crying foul, saying the rules shouldn't have been changed to allow for such gains.

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The emergence of debt-induced gains, even if they only offer a slight respite from overall market woes, has rekindled longstanding debate about whether such profits should be allowed. The opportunity for companies to benefit in this way only recently emerged, thanks to new accounting rules that allow companies to apply market prices to their own liabilities.

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Even some supporters of the use of market, or fair, values remain uneasy with companies booking gains on declines in the value of their own debt. "It was premature to allow the effect of that to come through the income statement," said Leslie Seidman, a member of the Financial Accounting Standards Board, the body that adopted the rule that allows companies to book these gains.

Yet brokerage executives defended the gains, saying they were more than just an accounting gimmick. During his firm's earnings call, Sam Molinaro, Bear Stearns's chief financial officer, said "the gains were real," adding that "there's someone on the other side of that trade who lost money."

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The idea of allowing companies to profit from falls in their own liabilities proved controversial when accounting rule makers debated the idea. But many companies, especially in the financial sector, argued that if the rule makers were going to encourage the use of market values, they should allow companies to use them for all their financial assets and liabilities. In addition, financial firms argued that it didn't make sense to require them to use market prices for the value of a derivative contract that may be hedging the value of a company's own liabilities, which would be recorded at its cost.

Ok now, whoa. There are a lot of moving parts here. Let's take a big step back and sort this out. We've got cash instruments, assets and liabilities. We've got derivatives. We've got derivatives hedging cash instruments. We've got issues of liquidity. Each one of these items needs to be considered before developing a policy that makes sense for firms and financial statement users alike.

Here's Roger's Guide to Intuitive and Useful Accounting Policies and Practices.

Assets: You need to distinguish between trading assets and non-trading assets. Trading assets should have an explicitly low duration, not the instruments themselves but the amount of time they are likely to be held in the book. Trading assets should be marked-to-market. Always. Non-trading assets should be carried at cost, with a valuation reserve that fluctuates based on market values but whose changes flow through the Stockholders Equity account as a discrete line-item. This should also take into account permanent impairments, the impact of which would flow through the valuation reserve. As these non-trading assets are sold their carrying value is removed as well as any valuation reserve associated with their disposition.

Liabilities: Here you need to distinguish based on intention and ability, and there should be a document carried in the file that states the specific intention towards specific financial liabilities and the capacity to exercise these intentions. If a liability is not expected to be extinguished, i.e., it is a core part of a firm's financing structure even if its value declines, it should be carried at the maturity value. I don't buy Mr. Molinaro's argument at all. I think it is disingenuous to say "Oh, well, I could buy back that debt at a discount. The gain is real." Companies just don't buy back debt at the drop of a hat. It is not like selling a trading asset. I'd argue that the pool of liabilities that are true "trading liabilities" is actually very small, and, therefore, most of a firm's debt should not be marked-to-market. That said, if a firm can make a case for and has a history of treating some of its debt in this manner, then it is fair to mark it to market just as it does trading assets. But my sense is that the number is quite small and instances such as these should be documents for absence of doubt.

Hedged assets and liabilities: The accounting profession has gotten this wrong for a long, long time. Believe me I know - as a derivatives pro I lived this nightmare during every single transaction. I think you need to keep it simple. The concept of "effectiveness" exists in the realm of derivatives accounting, i.e., does the change in the value of the hedge offset the change in value of the hedged instrument? Fair question. But the process of testing and designating effectiveness is way, way too onerous and time consuming. Punch line: is a hedge 90% effective using some reasonable tests (and I mean reasonable) set forth by your auditors? If yes, leave the hedged assets or liabilities carried at purchase price/maturity value. If not, then mark-to-market both instruments and have the difference in values flow through the valuation reserve. Preserve the integrity and usefulness of the income statement while providing mark-to-market detail on the balance sheet.

All I know is that the divergence between accounting theory and financial statement usefulness has gotten us off the rails. A little common sense needs to come back into the equation before financial statements become so convoluted and complicated that their usefulness simply erodes. Unfortunately, the wheels of the accounting rule-making process are slow, fraught with politics and sometimes lead to the wrong answer. Mr. Paulson, can you help here?

Comments

[Michael]

Thought you might have missed [AGO] price action after they announced M2M in a press release...

[Speculator]

I have noticed the use of this already by Mortgage REITS that are imploding - TMA and KFN for instance. Both are active trying to attract new money to bail them out of their issues - and both published mid quarter book values that included writing down their liabilities (which were trading for crap given their distress) so that helped them to up the book value!

Get distressed - increase the value off your equity!?!?!!? Sell more stock to clueless equityholders - its a great system.

[Rob]

Roger,
I blame the auditing community for allowing much of this nonsense to propagate. My wife is an auditor, and she is constantly frustrated by the argumentative nature of companies, be they large, small, or even non-profits. Audits are not viewed as a check-and-balance procedure to insure good accounting policies, but rather, as a rubber stamp needed to please investors or the government. As a result, audits are won by the low bidder, who then must staff them with a bunch of new college grads who are barely supervised by someone with decent experience. If the auditors cause too much ruckus, they lose the audit and the company chooses someone else who is better at "going with the flow." For my wife, who is one of those people intrinsically motivated to follow the rules and do the right thing, she's been in a lot of heated battles with CFOs who, even when acknowledging errors, will argue endlessly about why they shouldn't be put in the audit report.

The problem is that the incentives are all misaligned. Until that changes, companies are going to take full advantage of aggressive accounting policies.