Archive for March, 2009

Is Fair Value Accounting ..Well….Fair?

There has been much discussion during the last few months on the role of accounting in the recent economic downturn.  Specifically the concept of mark to market accounting has absorbed much attention. 

 

Simply stated, mark to market accounting requires businesses to periodically revalue their financial assets and liabilities to current market values.  The increase or decrease in the value is then typically booked as a profit or loss.  Financial institutions are most heavily affected by this accounting treatment as their entire business consists of financial assets and liabilities. 

 

When the market value of assets is rising, there are high fives among the financial analysts, the CEO’s liquor cabinet is flung open and the AP clerks start getting expense reports with “dinners” at restaurants with odd names like Club Ecstasy.  Times are good!  The balance sheet is growing and gains are being recorded on the income statement. 

 

When asset values decrease, it’s suddenly not all fun and games in the boardroom as fingers are pointed, expenses are questioned and the 30 year old scotch suddenly disappears. 

 

The traditional accounting approach, in place since the 15th century, has been the historical cost principle.  This principle requires companies to record assets at their cost or the market value; whichever is less. 

 

In other words, assets are periodically evaluated and can be reduced in value; but never increased.  This approach is clearly the more conservative one but it has many detractors especially in the investment community.  Some investors find little value in historical costs especially if market values have risen significantly.  These investors believe that the “market value” of the assets should be reflected in the company’s financial statements. 

 

Some of you may be asking at this point, “Who cares?”  This is an understandable perception given the popular image of accounting as a clear cut discipline with little real impact on business performance.  After all isn’t it just a matter of adding up the revenues and expenses and subtracting one from the other?

 

To understand the implications of fair value we have to begin with the importance of accounting to our economic system.  Central to capitalism are the identification of prices and the calculation of profit and loss.  Those managing businesses depend on this information in order to evaluate the business decisions they have made. 

 

The most important evaluation managers make is did their decisions result in profits or losses?  Moreover, investors, bankers and business partners use accounting data to allocate investment resources, extend credit and evaluate joint ventures. 

 

Now that we have established the criticality of accounting data, we can turn back to evaluating the mark to market vs. historical cost approaches. 

 

Using mark to market accounting results in more flux or volatility in the company’s financial statements, as asset values are increased and decreased and profits and losses are recorded.  This makes it more difficult to ascertain whether profits and losses are attributable to business decisions made by management or the vagaries of the market. 

 

Another problem arises when attempting to alter asset values to “market.”  Who determines the market price?  This may seem elementary as we think of heavily traded stocks or bonds but how about Collateralized Debt Obligations for example?  Unfortunately you can’t price those at your local 7-11. 

 

Despite all of these difficulties, using mark to market accounting is not impossible.  It simply requires more attention and discipline from management, auditors and investors. 

 

The danger arises when mark to market accounting in particular, and overall accounting in general, becomes seen as the “cause” of economic losses.  For example, there have been recent calls to suspend mark to market accounting for financial institutions by various public personalities.  Accounting is erroneously seen by some as the cause of the losses being taken by the financial institutions as their assets are marked down.  . 

 

Responding to this outcry, Congressmen Perlmutter and Lucas have introduced HR 1349 in the House of Representatives.  This bill proposes to create something called the Federal Accounting Oversight Board (FAOB). 

 

The bill proposes that the FAOB not only approve and oversee accounting principles and standards in the United States but also be granted the power to suspend, temporarily or permanently, any accounting principle or standard.  The specific language used is as follows (Emphasis added):

 

“In approving and overseeing such accounting principles and standards, the FAOB shall consider– whether certain accounting principles and standards should apply to distressed markets differently than well-functioning markets;

 

“If any Federal financial regulatory agency determines that any accounting principle or standard approved by the FAOB, or any accounting principle or standard in effect on the effective date of this Act, has an adverse effect on the safety and soundness of the entities it regulates, the health of the United States financial system, or the United States economy, the agency may request authorization from the FAOB to review such accounting principle or standard for the agency, and the FAOB shall determine whether the standard or principle should continue to be applied or instead removed on either a temporary or permanent basis.

 

A wise CEO once told me that if you have two watches you never can tell what time it is.  Oscillating accounting standards, one set for prosperous times and another set for use in economic downturns, masks the true performance of a business, results in accounting information being rendered useless and leaves company management without the feedback information they require to satisfy consumer demand. 

 

There are good arguments for both the historical cost approach and mark to market accounting.  The issue is that mark to market accounting is more volatile and therefore requires a certain discipline to uphold its integrity.  If we are willing to accept gains on the way up we must surely be willing to take losses on the way down. 

 

 

Until next week,

 

 

 

Michael Bechara, CPA
Managing Director

Granite Consulting Group Inc.

mbechara@consultgranite.com

www.consultgranite.com

 

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Spending Our Way to Paradise

“What has always made the state a hell on earth has been precisely that man has tried to make it his heaven.”  - Friedrich Hölderlin

 

Can an entire economy really be managed to ensure prosperity for all? 

 

Around the globe governments are overheating from activities designed to prevent a recession.  The medicines range from bailouts and money printing to lavish government spending. 

 

The unbridled hope is that through these interventions the government will induce people into acting a certain way and thereby make economic life better for the whole population.  The fact that these policies may have not only unintended consequences, but likely unimagined consequences, has not yet been thoughtfully considered.    

 

We find it fascinating that the debate centers on what mix of medicines the government should administer.   For us, the most interesting questions are: Will the medicine work?  Will it have its desired effect?  Can we really eliminate the negative consequences of economic decisions?

 

The answers to these questions depend on one’s view of economics itself. 

 

To some, economics is viewed as an empirical science, similar to chemistry or biology.  It is a discipline governed by unchanging laws and underpinned by assumptions of how people should behave.  To others economics is the combined result of individuals’ choices.   

 

Amongst those that view economics as a science, grand mathematical models and projections are often constructed and used to forecast and explain economic activity.  At the heart of these models are the assumptions that individuals have “perfect information” and will act “rationally”.  Based on these models the various bailouts and spending plans are formulated and presented as a solution to the current economic problems. 

 

Coming from a family of scientists, I can tell you that what are often called the “laws” of economics” certainly do not behave as what we normally think of as laws of nature.  For example, in physics the theory of gravity can be empirically tested by dropping an apple from a table.  Each and every time the apple will drop and hit the floor, (ceteris paribus) thereby proving the theory of gravity. 

 

Economics; however, deals with people’s behavior.  The supply and demand for goods/services are governed not by some unchanging law but by the decisions people make regarding buying and selling.  Moreover, these decisions do not always conform to the assumptions of perfect information and acting rational.   

 

I don’t know about you my friends, but my wife continually reminds me that she is the only person that possesses perfect information.  We have also seen people in our lifetime that appear to act irrationally and against their own self interest.  Ever witness a housing bubble by any chance? 

 

But hey who are we to judge?  We can’t identify the quality of information that people possess or what is in someone else’s self interest anymore than the US Treasury Department can.  The only small difference is that we don’t have the power to reallocate the resources of an entire economy. 

 

On the other hand, there are those who view economics more organically and less presumptively.  The economy is viewed as an amalgamation of individual choices regarding buying, selling, investing, saving, etc.  These choices may be made rationally, irrationally, intellectually, emotionally, etc.  All of these choices have consequences; some positive and some negative. 

 

From this standpoint, it is hard to see how exactly the bailouts, inflation and government spending can be relied upon to ensure people act in a certain way.   

 

Indeed, these interventions often do not have their desired effect.  For example, the loose monetary policies of the past several years were designed to “get us through” the tech bubble burst, 9-11, and various other crises.  Did anyone expect the result to be a speculative bubble in real estate, fueled not by savings, but by securitization and an alphabet soup of financially engineered vehicles?  Did anyone expect the entire banking system to be nearly vaporized as a result?  

 

Rather than more experimentation based on faulty assumptions, the economy simply needs to be cleansed.  Mal-investment must be cleared from the system through failures and bankruptcies.  The market will reallocate capital and resources to those more competent in managing them.  Providing more money to those who have already failed will not only encourage future failure, it will delay the healing process. 

 

Failure has gotten a bad name anyway and unfairly so in our opinion.  Failure is part of life’s natural feedback loop.  Individuals and businesses make various economic decisions and assess the results which are then used in future decisions.  The astute even learn something from the failure of others.

 

Without failure there can be no success.  If we eliminate one, we also eliminate the other.  In my own life I have learned that the greatest failures have often been the beginnings of my greatest successes. 

 

Perpetual prosperity for all is a concept not of this world.  For such an ideal we look to the theologians.  It’s fairly certain; however, that if we continue trying to predetermine economic outcomes and erase bad decisions, we will have prosperity for none. 

 

 

Until next week,

 

 

Michael Bechara, CPA

Managing Director

Granite Consulting Group Inc.

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The Ghosts of Long Island

I am not from Long Island. I don’t have any family on Long Island nor do I work on Long Island. So why write this piece on Long Island? Simply because there is something there that is instructive.

Over the past years I have traveled to Long Island many times for business. In the early days I made a quick judgment on the place. Typical suburbia I thought, the classic bedroom community. As my trips there increased, I slowly came to realize there is something else there, something I could not describe for a long time.

There is something hanging over Long Island, in the backyards, in the pools, in the baseball diamonds. Something about the place…As I learned more about Long Island over the years, I began to understanding the Island and more importantly….the people.

Almost the entire historical ethos of Long Island has been as a place to get good work and raise a family. In the 1950s, refugees came streaming in from New York City’s stifling living arrangements and found the open spaces inviting and affordable.

They also came for the jobs, specifically the high paying manufacturing jobs. Jobs that could pay the mortgage, the bills and still allow some discretionary spending.

Yes, Long Island was a place that made things. What kind of things? There were gasket manufacturers and cabinet makers and so forth and they did well enough, but it was the Aerospace and Defense industry that was the crown jewel in the Island’s economy.

For example, no area in America had more of an impact on World War II than Long Island. This was the first war won primarily in the air, and two Long Island companies, Grumman (of Bethpage) and Republic Aviation (of Farmingdale) deserved much credit.

These companies and others like them provided many good paying jobs. Today these companies are either no longer in existence or are a shadow of their former selves. So what happened?

Someone got a bright idea.

“Manufacturing is a dirty business.” Definitely not suitable for Americans. There are other people who should be doing this type of work while we sit back and enjoy the good life of a clean service economy”, the experts promised throughout the ’80s and ’90s. Americans would do the brain work and others would perform the tough job of making things.

What a great idea! “We can do some drawing and figuring and others will do the dirty work, many said. The service economy is the future! So Long Island and America began to divest themselves from their industrial capacity.

The idea took hold. Globalism was hailed as the new future of the country. Books were written about how “the world is flat again.” “History is over”, pronounced one expert and perhaps most famously, “Deficits don’t matter” claimed a high government official.

But how was a service economy supposed to work, some of us wondered. Isn’t this like the apocryphal story of the village that made its living by taking in each other’s laundry?

Sadly, the idea was a chimera. Manufacturing businesses support services businesses. By definition any service business whether finance, hair cutting and yes, even our own precious business of consulting, cannot exist in the absence of the ability to produce goods.

After the service economy didn’t pan out, the brain trust told us, “No no forget services! We are going to have an Information Economy.” Remember the late ’90s anyone? How many people does Pets.com employ today? Well now that idea has run its course, so finally for those who would be PT Barnum’s favorites, we are told there is going to be a Green Economy!

Service, Information and Green economies are fantastical aberrations meant to obscure the fact that we have willingly given up our industrial capacity and now depend on others to manufacture the necessities of modern life.

Now back to Long Island. As I continued to travel to Long Island throughout the years, I saw the history of the place reflected in its people. Whenever the subjects of the Defense Industry, growing up on the Island or even just general economics came up, the people seemed to have a melancholy air about them.

The look that came over their faces was one of those who have lived through a golden age and know that it will never return. Many of them have seen family, friends and even those they really didn’t like, move off the Island in search of better jobs and better opportunities.

I once sat next to the president of a Long Island community organization on a flight to Virginia and he confessed to me the biggest challenge his organization has is keeping young people on the Island. “They graduate from college and go to the Southeast or out West”, he said.

Funny how the two places mentioned by the community leader are places that either have some semblance of manufacturing activity (Southeast) or are centers of the “New Economy” de jour (West).

So they no longer come back to the Island to work and raise families. Indeed this is part of a larger trend we see in our country. There is the deindustrialization and the subsequent under employment that follows as people cannot replace the wages they earned in manufacturing.

The needs of the “World Economy” have been confused with the needs of our own. We have witnessed the greatest transfer of wealth the world has ever seen from America to the developing world. They send us manufactured goods and we send them our dollars.

So who is responsible? Can blame be exclusively assigned? No, there are too many culprits…too many that believed in the wrong things.

We are reminded; however, of General Douglas MacArthur’s farewell speech to the cadets at West Point in 1962. At the climax of the speech, General MacArthur cautioned the cadets against failing in their capacity as leaders:

“The long gray line has never failed us. Were you to do so, a million ghosts in olive drab, in brown khaki, in blue and gray, would rise from their white crosses, thundering those magic words: Duty, Honor, Country.”

My dear friends, in the churchyards and cemeteries of Long Island, the cries are deafening.

Until next week,

Michael Bechara
Managing Director
Granite Consulting Group Inc.

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