Mark-To-Monkey-Business Accounting?

The subtitle for this post: Is FASB channeling the ghosts of Arthur Andersen? The answer to these questions would be ‘yes’ according to two recent writers.

Recall that in the first installment of the mark-to-market soap opera, we distinguished between assets that required marking (i.e., pricing) to some current and active market, marking to financial models (“mark-to-model”), and marking to management’s rough estimate (“mark-to-myth”).

It now appears that the assault on the old ways may be bearing some rotten fruit.
In the Next Round of Bank-Based Appeasement, a Seeking Alpha writer unloads on three potential accounting changes.

First:

Consider the bill sponsored by Representative Ed Perlmutter of Colorado - the "Federal Accounting Oversight Board Act of 2009." It fairly bristles with the kind of rewards the banking industry would love: better than bonuses, it could give them the kind of regulation they want. The bill would transfer the SEC's oversight of the FASB to the new "Federal Accounting Oversight Board." Look at its mission - it's a banker's dream come true:

(1) APPROVAL OF ACCOUNTING POLICY- The FAOB shall approve and oversee accounting principles and standards… the FAOB shall consider--

(A) the extent to which accounting principles and standards create systemic risk exposure for--

(i) the United States public;
(ii) the United States financial markets; and
(iii) global financial markets;

[…]

(C) whether certain accounting principles and standards should apply to distressed markets differently than well-functioning markets;

(D) the balance between investors' need to know a value of a company or financial institution's balance sheet at any given time versus financial regulators' responsibility to examine a company or financial institution's capital and value on both a liquidation and going concern basis;

[…]

(G) the need for accounting principles and standards to take into account the need for financial institutions to maintain adequate reserves to cover expected losses from assets held by such institution

[…]

It's downright Orwellian: to protect the public, this "oversight body" would blind them from the mistakes made by financial institutions by making accounting less transparent. The body has right to determine "the balance between investors' need to know a value of a company's balance sheet ... versus regulators responsibility to examine capital?" Doesn't that mean that the actual owners of an institution take a back seat to the regulators' decision to keep them in the dark about its true condition?

Truly incredible stuff. This bill wouldn't just turn the asylum over to the inmates; it would arm them with pistols and napalm, too.

Something does smell a little off in the state of Denmark. Could this be an accounting murder most foul? Point 1A is curious with its emphasis on ‘create.’ It seems to me that the real focus here should be the extent to which accounting principles and standards expose the foolish systemic risk taken on by financial institutions and subsequently dumped onto the public. Create or expose? I guess it depends on whose ox is being gored. Point 1G seems postmodern enough. Financial institutions get levered up to Pluto so that a small drop in (illiquid) asset values wipes out reserves. Do we fix this problem by requiring more reserves? Pish posh! We just need make sure accounting principles and standards “take into account” this massive leverage. What solvency issue?

Second:

On Tuesday the FASB released two exposure drafts that tinker with the edges of fair value reporting.

[…]

First up: FSP FAS 157-e, "Determining Whether a Market Is Not Active and a Transaction Is Not Distressed," which is intended to help preparers and auditors determine when a financial asset's trading price is affected by illiquid markets or a distressed transaction. It provides a list of indicators of illiquid markets; upon reviewing, if the preparer judges the securities in question to be trading in an illiquid market, it must take a second step.

That second step is a presumption that the price is associated with a distressed transaction; it's a presumption that can only be overcome by evidence that sufficient, usual and normal marketing activities occurred for the asset before measurement date, and that multiple bidders existed for the asset. If those conditions aren't met, then the asset must be valued using a valuation technique other than one that uses the quoted price without significant adjustment.

Bottom line, this will grease the skids for the expansion of "Level 3" valuations.

Mark-to-market, mark-to-model, or mark-to-monkey-business? Po-tay-toe, po-tah-toe.

Third:

Next: FSP FAS 115-a, FAS 124-a, and EITF 99-20-b, "Recognition and Presentation of Other-Than-Temporary Impairments." This tweak will create a broad class of new long-term corporate investors in both debt and equity securities. Why? Because a firm will not recognize an other-than-temporary [OTT] impairment charge through earnings if it does not intend to sell an impaired security, and it is more likely than not that the firm will not have to sell it before the recovery of its cost basis. Therefore, we will likely witness an outbreak of "patient capital."

[…]

Net result: if OTT impairments ever do occur, the hit to earnings will be less than they are now, all else equal. Accumulated other comprehensive income will take a blow for the non-credit loss charges - but financial institutions won't mind because it won't affect regulatory capital. Charges through the income statement definitely affect regulatory capital, and they'll decrease. And earnings will be so smooth, they'll make a baby's bottom look like 20 grit sandpaper.

In more accessible language, here’s what a Bloomberg commentator has to say on this one in his colorfully titled Accounting Brothel Opens Doors for Banker Fiesta.

This week, the Financial Accounting Standards Board unveiled what may be the dumbest, most bankrupt proposal in its 36-year history….
Here’s what the board is floating. Starting this quarter, U.S. companies would be allowed to report net-income figures that ignore severe, long-term price declines in securities they own. Not just debt securities, mind you, but even common stocks and other equities, too.

All a company would need to do is say it doesn’t intend to sell them and that it probably won’t have to. In most cases, it wouldn’t matter how much the value was down, or for how long. In effect, a company would have to admit being on its deathbed before the rules would force it to take hits to earnings.

[…]

A FASB spokeswoman, Chandy Smith, confirmed my understanding of how the rule change would work.

[…]

Under the current rules, securities get differing accounting treatments depending on how they are classified on the balance sheet. When labeled as trading securities, they must be assigned marked-to-market values each quarter, with all changes flowing through to net income. Otherwise, changes in value don’t hit the income statement, unless the securities have suffered what the accountants call an “other-than-temporary impairment.”

While the term may be cumbersome, the idea is that companies need to show losses in net income once they no longer can pretend that an asset’s plunge in value is only fleeting…..

The board’s proposal tosses the old principle aside. Even if a loss is deemed not temporary, companies still would be allowed to keep it out of net income. There’s one exception: If a company holding debt securities concludes some of the decline is due to credit losses, that portion would need to be included on the income statement. Otherwise, the losses stay off.

You just know how this will turn out: Debt holders will say their losses almost always are due to something other than credit losses, such as liquidity risk, because it’s impossible to prove their judgments wrong. So the dents to net income will be minimal. That’s exactly what the FASB is trying to accomplish.

The saga continues…