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
Granite Consulting Group Inc.