SEC and FASB Relax Fair-value Accounting Rules

SEC and FASB slightly relaxed the mark-to-market accounting they have been championing for years. It will probably have little impact and it's a bit too late but at least they are seriously thinking about the issue. My expectation is that the whole system will be completely revamped or dumped completely within 10 years. It'll take a while because my impression is that accountants are schooled in efficient markets and don't really understand how asset prices can be misleading during stressful times.

Statement 157 went into effect for financial institutions starting in November 2007. The accounting treatment is applied to certain assets, such as mortgage-backed securities. Using the method, asset values are determined by what sales-price those assets would fetch in the current marketplace from a buyer, not necessarily the price a seller would hope to get.

In theory, this gives investors more information about how much of an investment bank's value is based on hard-to-value assets. But the new approach came along at a tough time for banks, which were left with huge exposures to mortgage-backed securities, and more complex mortgage-related assets known as collateralized debt obligations, after the recent real estate boom.

As delinquencies and foreclosures soared this year, investors became wary of trading these types of securities, making them much harder to value. When trades have happened, they've often been at steep discounts.

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In one clarification, the SEC said firms can use management assumptions and other factors about "future cash flows" to measure the value of asset if no market exists.

In another example, the SEC said firms don't have to take into account an asset fire-sale at another institution to measure the fair value of their own exposures. This occurred when Merrill Lynch sold $30.6 billion of collateralized debt obligations at 22 cents on the dollar in late July.

Here is an opinion piece from 2006 critical of fair-value accounting. The article is about the misleading financial statement of Enron due to fair-value accounting but I think the misleading assets being reported presently for financial institutions is a bigger issue. I don't think the author would have imagined how powerful and distorting fair-value accounting would be. Enron is a joke compared to what is happening right now:

Most investors and creditors have an image of accountants as professionally careful and conservative. Even recent accounting scandals are viewed as an aberration that will be addressed by changes in law, oversight, and penalties. This benign, conservative view of accountants may change as the real meaning of Enron becomes clearer with time. The last 30-odd years have produced a paradigm shift in corporate accounting theory. The new theory assumes that the 412-year-old “accounting model” is broken and must be replaced by an “economically satisfying” method for valuing assets and liabilities. Implementation of economic valuation techniques requires that accountants abandon traditional accounting principles (historical cost accounting, conservatism, and matching of costs and revenues). Yet, the movement toward fair value accounting (the general name for economic valuations) has been undertaken without evidence that the valuations produced are actually “better” than the old valuations. In contrast, recent evidence indicates that use of fair valuation has the potential for spectacularly misleading results.

The real big concern for those critical of fair-value accounting are the level 3 assets of financial institutions. There is a huge amount tied up in these illiquid, hard to value, assets and if they are marked down to market (price will probably be close to zero than to par/original value,) I suspect many banks will go bankrupt overnight.