How To Fix the Broken US Economy (Part 4)
Interesting Accounting

By Guest Author Bill McGinnis, CFA

I know it’s a lot to promise in a title that accounting will be interesting. However, if you think about it, that’s not necessarily what the title says. With a little bit of thought, you’ll realize you don’t know exactly what is coming next.

The same is true of a recent hot topic, which often goes by the name fair value accounting. These carefully chosen words misrepresent the facts. It is more accurate to refer to the more technical name: mark-to-market accounting.

In the old days, accounting was about facts. It was a historical compilation of known events. Everything on financial statements was recorded at actual transaction values.

That approach was fraught with problems. What if the value of something dropped significantly? That information wasn’t reflected in the financial statements. What if the value of something appreciated significantly? Likewise, this also wasn’t reflected.

Thus, financial statements, while accurate from a historical perspective, often failed to communicate the current situation very well. Among the financial professionals who most often used these financial statements (bankers, investment analysts, portfolio managers, etc.), there was near uniform belief that more information would not only be valuable, it would be desirable. More changes have been made in recent years.

This wasn’t a sudden revelation. Decades, possibly centuries, passed with much discussion about the inadequacies of accounting figures. However, in the 1990s, it was decided that accounting changes would be implemented to more accurately reflect “fair value”.

Why hadn’t this been done years or decades earlier? Because mark-to-market accounting is also fraught with problems. The conclusion is that there is no accounting panacea.

While the old-form accounting was inaccurate, at least it was precise. You knew with certainty the price at which a transaction occurred. With mark-to-market accounting, there is no transaction. In many cases it relies upon approximations, estimations, assumptions, valuation models, and educated guesses.

Mark-to-market accounting generally seems simple and reasonable on the surface. It seems reasonable to expect that the accountants simply look at the assets on the balance sheet and adjust them to current market prices. However, if it were that simple, it would have been done long ago.

Thus, the shift toward mark-to-market accounting began with the easiest category, financial assets. Most readers will quickly imagine how this could work. There are 50,000 shares of XYZ Company on the balance sheet. At the end of the year, the accountants look up the closing price of XYZ shares and adjust the value of the shares on the balance sheet accordingly.

That’s all well and good, but in the real world few assets are as interchangeable as shares of stock. Obviously, one share of XYZ Company is worth the same as the next share of XYZ Company.

But what about a 5-year 8.37% bond of XYZ Company that is not traded on any financial exchange? Now the accountants have to find a “similar” transaction. Maybe they can find a 5.2-year 7.82% bond of ABC Company that has been purchased recently. Obviously, these bonds aren’t exactly the same. Not to mention that there could be significant differences between the strength and quality of XYZ Company vs. ABC Company. We still haven’t considered the fact that bonds are not just a simple loan. Bonds are backed up by extensive legal documents that explain the legal rights of the bondholder. These rights can vary considerably and can have a dramatic affect on a bond’s value.

How can the price of the ABC bond be adjusted to reflect the value of the XYZ bond? Approximations, estimations, assumptions, valuation models, and educated guesses.

While this hopefully makes it apparent that determining a value to mark to is not a science, the bond example is actually a rather simplistic one. Many financial assets are much, much more complex than the bonds in this example.

Unfortunately, we haven’t even gotten to the real problem at issue since last fall. Mark-to-market would be more clearly stated as Mark-to-market-value. Market value is generally assumed to be a reasonable approximation of the value of something.

This is where there has become a divergence in opinion among financial professionals. Some argue that the last price is the market value regardless of circumstances. Others argue that, as has been the case since last fall, during periods of market disruption, the last price may not accurately reflect true value.

In an email I wrote in September 2009, that went to many politicians, including President Obama, I suggested that mark-to-market accounting should be suspended for five years. I made this suggestion due to the significant financial market collapse that had taken place. Due to substantial economic uncertainty, the market for many types of financial assets virtually disappeared.

Mark-to-market suggests that there actually is a market. Such was not the case then…and in many ways it remains unchanged. Thus, accountants are forced to revalue balance sheet items to prices at which most reasonable people would not sell them. The only sales that have taken place have been “fire sale” situations, which don’t necessarily reflect long-term value.

In other words, the financial statements are not communicating any more clearly than they were before the implementation of mark-to-market accounting. They are only communicating differently.

For many companies, this isn’t a significant issue. However, for regulated financial companies, it can be life or death. They are required to maintain a certain percentage of capital (capital is largely the same as equity) relative to their assets. When assets are marked down based on mark-to-market accounting, the same amount is subtracted from capital. This causes a vastly disproportionate decline in the capital ratios.

Thus, companies that are forced to take substantial mark-to-market write-downs may appear to be failing. However, in many cases, they not have sustained any actual losses and may not sustain any in the future. It is possible for the appearance of distress to simply be a temporary accounting anomaly. That’s not what accounting is supposed to do.

There are other substantial problems with mark-to-market accounting. Not only are assets revalued, but liabilities as well. Ironically, when a couple of banks recently reduced the value of certain liabilities based on mark-to-market adjustments, there was a huge uproar from some financial professionals. Some went as far as to suggest that it was unethical. They were comfortable with applying mark-to-market accounting to assets, but not to liabilities. Where is the logic in that?

To further complicate matters, not all assets and liabilities are adjusted based on mark-to-market accounting. Therefore, we end up with apples and oranges financial statements. At least in the old days it was all apples. Consistency, clarity, and accuracy are keystones to accounting and to the foundation of strong financial markets. We have lost these.

Why not just change back to the old historical value approach to accounting? Many financial professionals are concerned about the lack of information. I agree. However, it seems that just as much information could be conveyed (possibly even more) by including market value information in the footnotes to financial statements, rather than in the financial statements themselves. It would actually be clearer that the information being conveyed lacks the precision we are supposed to expect from financial statements.

Mark-to-market accounting was an interesting theory that has proven to be a mistake. It has exacerbated, if not caused, the current financial crisis. There is still time to rescind this failed approach. The good news is that it would not cost another trillion dollars or two trillion dollars of bailout, stimulus or recovery money. It would cost NOTHING.

When it comes to accounting, interesting isn’t necessarily a positive.

This segment is part 4 in the series : How To Fix the Broken US Economy
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