Accountants Gain Courage to Stand
Up to Bankers
Turns out America’s accounting poobahs have some fight in them after all.
Call them crazy, or maybe just brave. The Financial Accounting Standards Board is girding for
another brawl with the banking industry over mark-to-market accounting. And this time, it’s the FASB that has come out
It was only last April that the FASB caved to congressional pressure by passing emergency rule changes so that banks and insurance
companies could keep long-term losses from crummy debt securities off their income statements.
Now the FASB says it may expand the use of fair-market values on corporate income statements and balance sheets in ways it never
has before. Even loans would have to be carried on the balance sheet at fair value, under a preliminary decision reached July
15. The board might decide whether to issue a formal proposal on the matter as soon as next month.
“They know they screwed up, and they took action to correct for it,” says Adam Hurwich, a partner at New York investment manager Jupiter Advisors LLC and a member of the FASB’s
Investors Technical Advisory Committee. “The more pushback there’s going to be, the more their credibility is going to be
The scope of the FASB’s initiative, which has received almost no attention in the press,
is massive. All financial assets would have to be recorded at fair value on the balance sheet each quarter, under the board’s
This would mean an end to asset classifications such as held for investment, held to maturity
and held for sale, along with their differing balance-sheet treatments. Most loans, for example, probably would be presented
on the balance sheet at cost, with a line item below showing accumulated change in fair value, and then a net fair-value figure
below that. For lenders, rule changes could mean faster recognition of loan losses, resulting in lower earnings and book values.
The board said financial instruments on the liabilities side of the balance sheet also would have to be recorded
at fair-market values, though there could be exceptions for a company’s own debt or a bank’s customer deposits.
The FASB’s approach is tougher on banks than the path taken by the London-based International
Accounting Standards Board, which last week issued a proposal that would let companies continue carrying many financial assets at historical cost, including
loans and debt securities. The two boards are scheduled to meet tomorrow in London to discuss their contrasting plans.
While balance sheets might be simplified, income statements would acquire new complexities.
Some gains and losses would count in net income. These would include changes in the values of all equity securities and almost
all derivatives. Interest payments, dividends and credit losses would go in net, too, as would realized gains and losses.
So would fluctuations in all debt instruments with derivatives embedded in their structures.
Other items, including fair-value fluctuations on certain loans and debt securities, would
get steered to a section called comprehensive income, which would appear for the first time on the face of the income statement,
below net income. Comprehensive income now appears on a company’s equity statement.
Another quirk is that the FASB doesn’t intend to require per-share figures for comprehensive
income. Only net income would appear on a per-share basis. My guess is that means Wall Street securities analysts would be
less likely to publish quarterly earnings estimates using comprehensive income.
Imagining the Impact
Think how the saga at CIT Group Inc. might have unfolded if loans already were being marked at market values. The commercial lender,
which is struggling to stay out of bankruptcy, said in a footnote to its last annual report that its loans as of Dec. 31 were
worth $8.3 billion less than its balance sheet showed. The difference was greater than CIT’s reported shareholder equity.
That tells you the company probably was insolvent months ago, only its book value didn’t show it.
The debate over mark-to-market accounting is an ancient one. Many banks and insurers say market-value
estimates often aren’t reliable and create misleading volatility in their numbers. Investors who prefer fair values
for financial instruments say they are more useful, especially at providing early warnings of trouble in a company’s
“It’s been a religious war,” FASB member Marc Siegel said at last week’s board meeting. “And it’s been very, very clear to me that
neither side is going to give, in any way.”
So, the board devised a way to let readers of a company’s balance sheet see alternative
values for loans and various other financial instruments -- at cost, or fair value -- without having to search through footnotes.
At last week’s meeting, FASB member Tom Linsmeier called this a “very useful approach that addresses both sets of those constituents’
This will not satisfy the banking lobby, which doesn’t want any significant expansion
of fair-value accounting. “I guess the nicest thing I can say is it’s difficult to find the good in this,”
Donna Fisher, the American Bankers Association’s tax and accounting director in Washington, told me.
If the bankers don’t like it, that’s probably a good sign the FASB is doing something
A new discussion paper released last week by the staff of the International Accounting Standards Board has revived an old,
but still fiery fair-value controversy. At issue: the role of credit risk in measuring the fair value of a liability. According
to the paper's opening statement: the topic has "arguably ... generated more comment and controversy than any other aspect
of fair value measurement." When a company chooses to use the fair value method of accounting, it must mark its liabilities
as well as its assets to market. As a company's credit rating goes down, so does the price of its debt, which therefore must
be re-measured by marking the liability to market. The difference between the debt's carrying value and its so-called fair
value is then recorded as a debit to liabilities, and a credit to income.
Credit Risk in Liability Measurement >>> A paper prepared for the IASB by its staff... Comments to be received by 1 September
2009 (25 pages in PDF)
VRC (Valuation Research Corporation), a leading provider of valuations and value-related advisory services, recently completed
a survey of financial professionals views on Fair Value Accounting (FVA), also known as mark-to-market accounting. The survey
found a majority believed that market turmoil and the collapse of active markets for many assets caused implementation issues
in Fair Value Accounting. According to the survey, 58% of respondents believe that market turmoil negates Fair Value Accountings
validity. Further, of those who believed FVA was flawed and potentially not valid during market turmoil, almost 34% suggested
a temporary return to historical cost accounting as an alternative.
President Obama...presented a plan for regulatory reforms that would consolidate banking regulators, create new government
agencies and give new powers to the Federal Reserve. One proposal of particular interest to the accounting profession includes
three recommendations addressed to accounting standard setters. * clarify and make consistent the application of fair value
accounting standards, including the impairment of financial instruments, by the end of 2009 * improve accounting standards
for loan loss provisioning by the end of 2009 that would make the loan loss provisioning more forward looking, as long as
the transparency of financial statements is not compromised and * make substantial progress by the end of 2009 toward development
of a single set of high quality global accounting standards.
U.S. rulemaker eases mark-to-market's bite
FASB Reaffirms Original Principles of Fair Value (aka Mark-to-Market) Accounting and Requires
More Disclosures. Board Calls for Changes in Accounting for Impairments
The FASB considered three proposals yesterday. Two of the proposals were related to fair value
(mark-to-market) accounting, and one was associated with accounting for impaired securities, such as mortgage-backed securities.
The first proposal (on FAS 157) relates to how to figure out fair values when there is no active
market or where the price inputs being used really represent distressed sales. After considering all of the feedback we received
on our original proposal issued two weeks ago, the FASB yesterday reaffirmed that the objective of measuring fair value
has always been and continues to be the same since FAS 157 was published. [Emphasis in the original] The objective is
to reflect how much an asset would be sold for in an orderly transaction (as opposed to a distressed or forced transaction)
at the date of the financial statements. Specifically, yesterday's vote said that companies should look at factors and use
judgment to ascertain if a formerly active market has become inactive.
Once a company has made that determination, more work will be required to estimate the fair
value. In trying to estimate fair value in an inactive market, the company must see if the observed prices or broker quotes
obtained represent "distressed transactions". Other techniques such as a management estimate of the expected cash flows might
also be appropriate in that circumstance. However, even if a company analysis is used, it must meet the objective of estimating
the orderly selling price of the asset under current market conditions. Some financial institutions have made public statements
that they do not expect this proposal to significantly impact their financial statements.
The second proposal relates to fair value disclosures for any financial instruments that are
not currently reflected on the balance sheet of companies at fair value. The current rule is that fair values for these assets
and liabilities are only disclosed once a year. The Board voted yesterday that these disclosures should be required on a quarterly
basis, providing qualitative and quantitative information about fair value estimates for all those financial instruments not
measured on the balance sheet at fair value. For commercial banks, one financial asset impacted by this is loans, which will
now have disclosures about their fair value every quarter.
The third proposal deals with other-than-temporary impairment (OTTI). The proposal would not
change when a company recognizes impairment. It could change where [emphasis in the original] in the financial
statements the impairment is reported. Under the current rules, unless the severity and duration of a drop in fair value is
too great, if a company can assert that it intends and is able to hold a security until the fair value recovers, it need not
record an impairment charge on the income statement. The new proposal the Board approved indicates that no impairment charge
is required if there is both no current intention to sell and, it is more likely than not, that it will be required to sell
prior to the fair value recovering.* However, if management expects at the financial statement date that all of the cash flows
won't be 100% collected, an impairment must be recorded in the statement of income.
In certain situations, the proposal changes the presentation of the impairment charge, splitting
it up into two pieces. First, the amount of the impairment related to just the credit losses will be reflected on the income
statement and will reduce net income. Second, the amount of the impairment related to all other factors will be shown in other
comprehensive income in the equity section of the balance sheet. There will be a "gross" presentation of this on the income
statement, one which will clearly display the total reduction in fair value below cost, the amount offsetting it that is being
charged to other comprehensive income, and the net amount that is being recorded through net income.
Many balance sheet metrics used to analyze banks, such as Tangible Common Equity, should be
relatively unaffected by this proposal, though earnings, other comprehensive income and retained earnings would be impacted.
The Board did add significant new disclosures as part of this proposal as well.
Generally, these new proposals will be effective for the second quarter, though companies may
elect to adopt them for the first quarter. However, we indicated that if a company wants to adopt the impairment proposal
in the first quarter, it must also adopt the FAS 157 fair value in inactive markets proposal.
These proposals should be considered in the context of the larger ongoing joint project with
the International Accounting Standards Board (IASB) to reconsider accounting for financial instruments. A proposal on this
project is expected to be issued later this year.
*This sentence may be true for a HTM security but it is not true for an AFS security. For
an AFS security an impairment charge is required anytime the security's fair value is below cost since the measurement attribute
for AFS securities is fair value - it just maybe that the charge would go into OCI—instead of earnings if it is determined
to be not other than temporary.
Mark-To-Market Accounting Rules Must Die
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.
We are economists, not accountants
or bank analysts. We really don't think a debate about how big the housing bubble was, or whether a certain bank is viable
or not, is worthwhile when it comes to accounting rules. That misses the point. Mark-to-market accounting rules affect the
economy and amplify financial market problems.
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, a statement from the Federal Accounting
Standards Board, 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, so-called "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
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 U.S. 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 3,000 banks failed, without creating an economic catastrophe.
In Japan, during the 1990s, the
government allowed banks to operate without ever recognizing bad loans, which certainly bought time. However, Japan increased
taxes and ran an excessively tight monetary policy, which undermined growth. This created an economic disaster. 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 and
were not in bad shape like the Japanese banks. They stayed away from Japan because the economy was not vibrant.
A final example: In the 1930s, because
mark-to-market accounting existed, we limited the amount of time available to fix problems. At the same time, the U.S. raised
taxes, increased spending and economic interference, and became protectionist. This hurt growth. The reason the Great Depression
was so bad is that we took away time and growth.
Anyone worried about repeating the
errors of Japan in the 1990s or the U.S. in the 1930s should focus on the policies that impeded recovery. 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 and bank nationalization, is a recipe to undermine both time and growth and therefore hurt the economy even more.
Brian S. Wesbury is chief economist,
and Robert Stein senior economist, at First Trust Advisors in Lisle, Ill. They write a weekly column for Forbes.
Mark-to-Messy Accounting Change
Mark-to-market rules on valuing
assets have been softened. Expect banks, hard-pressed to right their balance sheets amid imploding markets, and their investors
to cheer. Not everyone is so happy.
The Financial Accounting Standards
Board voted Thursday to allow firms greater leeway in how they value illiquid assets. Currently, investments like mortgage-backed
securities are priced based on their last sale. Since the seller is usually distressed and parts with their goods for a fire-sale
price, all similar assets must be marked to a lower price.
Critics of this brand of "fair value"
accounting, outlined in FASB rule FAS 157, say it's crippled the banking system, forcing firms to continually write down the
value of assets in the worst possible market conditions, regardless of whether or not they're for sale. This, in turn, has
put tremendous strain on balance sheets, forcing financial companies to hunt for new capital to make up for paper losses at
a time when few investors are willing to put money into banks. The spiral devastated the industry.
As Forbes chairman and editor-in-chief
Steve Forbes has noted in repeatedly calling for ending mark-to-market rules, of the more than $700 billion that financial
institutions have written off, almost all of it has been book write-downs, not actual cash losses. "Mark-to-market accounting
is the principal reason why our financial system is in a meltdown. The destructiveness of mark-to-market--which was in force
before the great depression--is why FDR suspended it in 1938. It was unnecessarily destroying banks", he says (see: "End Mark To Market").
With the changes to rule 157, companies
can now value the assets on their books as if they were unloaded in an "orderly" sale rather than dumped in a forced or "distressed"
sale. The guidelines will apply starting in the second quarter, which began Wednesday.
Good news for these uncommonly bad
times, which demand bold remedies. But the point of FAS 157, critics of its repeal remind us, was to avoid the kind of dot-com
bubble, Enron-era mark-to-fiction accounting that artificially inflated the value of companies, leaving investors holding
the bag when optimistic company guesses met real-world market pricing. "[the changes] would basically give businesses more
leeway to decide what they report is on their books. That can't help investor confidence," says Espen Robak, president of
Pluris, a valuation advisory firm. "That means higher cost of capital for everyone."
The Center for Audit Quality, a
Washington, D.C.-based nonprofit, has said that letting firms make more subjective valuations will "reduce the transparency
that investors seek" and "would have significant unintended consequences."
One of the inadvertent effects could
be that current methods, based on recent transactions, are rendered incomplete, forcing firms to spend time and money trying
to assess what they have on their books. Investors will have to increase their own due diligence because reporting would be
less standard and some firms might be more optimistic than others. "The ones who will benefit are the ones who push the envelope
most," says Robak.
Another concern: The definition
of "illiquid markets" isn't clearly outlined. This is problematic because so many different types of assets aren't being traded
much from municipal bonds to many types of complex financial instruments. The proposal is meant to help de-clog balance sheets
by addressing the issues of certain unpopular investments, but it doesn't limit the scope of the rule change.
Others argue that a far simpler
way to help banks meet their capital requirements is to simply lower the capital requirements explicitly, instead of implicitly
doing so by letting them fudge the numbers. That approach has its own perils.
Accounting, in the end, is about
judgments and assumptions and, ultimately, convenient fictions. Accountants don't determine the real price of anything. Only
markets can do that. But they have to be functioning normally to do so. When they are aren't fair-value accounting does more
harm than good, but when order returns, we will be reminded why we need it.
Steve Forbes: End Mark-To-Market
is most astounding about President Barack Obama's radical economic recovery program isn't its breadth, but its continuation
of the most destructive policies of the Bush administration. These Bush policies were, in themselves, repudiations of Franklin
Delano Roosevelt, Mr. Obama's hero.
The most disastrous Bush policy
that Mr. Obama is perpetuating is mark-to-market or "fair value" accounting for banks, insurance companies and other financial
institutions. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts
when the market value of the financial assets they hold goes up or down.
Banks and life insurance companies that have positive cash flows now find themselves in a death spiral.
Of the more than $700 billion that financial institutions have written off, almost all of it has been book write-downs, not
actual cash losses. When banks or insurers write down the value of their assets, they have to get new capital. And the need
for new capital is a signal to ratings agencies that these outfits might deserve a credit-rating reduction.
Mark-to-market accounting is the
principal reason why our financial system is in a meltdown. The destructiveness of mark-to-market--which was in force before
the great depression--is why FDR suspended it in 1938. It was unnecessarily destroying banks.
If the president really takes Roosevelt's
legacy seriously, he should suspend mark-to-market accounting rules, restore the uptick rule and enforce the prohibition against
naked short selling. If he doesn't, historians will look back in utter amazement at Mr. Obama's preservation of Mr. Bush's
worst economic policies.
Banks and accounting standards
Apr 8th 2009
From The Economist print edition
Accounting rules are under attack. Standard-setters should defend them. Politicians and banks should back off
by Claudio Munoz
IN PUBLIC, bankers have been blaming themselves for their troubles. Behind the scenes, they have
been taking aim at someone else: the accounting standard-setters. Their rules, moan the banks, have forced them to report
enormous losses, and it’s just not fair. These rules say they must value some assets at the price a third party would
pay, not the price managers and regulators would like them to fetch. Unfortunately, banks’ lobbying now seems to be
working. The details may be arcane, but the independence of standard-setters, essential to the proper functioning of capital
markets, is being compromised. And, unless banks carry toxic assets at prices that attract buyers, reviving the banking system
will be difficult.
On April 2nd, after a bruising encounter with Congress, America’s Financial Accounting Standards
Board (FASB) rushed through rule changes. These gave banks more freedom to use models to value illiquid assets and more flexibility
in recognising losses on long-term assets in their income statements. Bob Herz, the FASB’s chairman, decried those who
“impugn our motives”. Yet bank shares rose and the changes enhance what one lobbying group politely calls “the
use of judgment by management”.
European ministers instantly demanded that the International Accounting Standards Board (IASB) do
likewise. The IASB says it does not want to be “piecemeal”, but the pressure to fold when it completes its overhaul
of rules later this year is strong. On April 1st Charlie McCreevy, a European commissioner, warned the IASB that it did “not
live in a political vacuum” but “in the real world” and that Europe could yet develop different rules.
It was banks that were on the wrong planet, with accounts that vastly overvalued assets. Today they
argue that market prices overstate losses, because they largely reflect the temporary illiquidity of markets, not the likely
extent of bad debts. The truth will not be known for years. But banks’ shares trade below their book value, suggesting
that investors are sceptical. And dead markets partly reflect the paralysis of banks which will not sell assets for fear of
booking losses, yet are reluctant to buy all those supposed bargains.
To get the system working again, losses must be recognised and dealt with. Japan’s procrastination
prolonged its crisis. America’s new plan to buy up toxic assets will not work unless banks mark assets to levels which
buyers find attractive. Successful markets require independent and even combative standard-setters. The FASB and IASB have
been exactly that, cleaning up rules on stock options and pensions, for example, against hostility from special interests.
But by appeasing critics now they are inviting pressure to make more concessions.
To reveal, but not to regulate
Standard-setters should defuse the argument by making clear that their job is not to regulate banks
but to force them to reveal information. The banks, their capital-adequacy regulators and politicians seem to dream of a single,
grown-up version of the truth, which enhances financial stability. Investors and accountants, however, think all valuations
are subjective, doubt managers’ motives and judge that market prices are the least-bad option. They are right. A bank’s
solvency is a matter of judgment for its regulators and for investors, not whatever a piece of paper signed by its auditors
says it is. Accounts can inform that decision, but not make it.
Banks’ regulators have to take responsibility. If they want to remove the mechanical link between
drops in market prices and capital shortfalls at banks, they should take the accounts that standard-setters create for investors
and adjust them when they calculate capital. They already do this to some degree. But the banks’ campaign twant. But
in doing so they must not compromise their duty to investors.o change the rules is making inevitable a split between two sets
of accounts, one for regulators and another for investors. The FASB and IASB can help regulators to create whatever balance-sheet
they want. But in doing so they must not
compromise their duty to investors.