New FASB Rule: is our Government Encouraging Accounting Fraud?

 by Deb Cupples | The Financial Accounting Standards Board (FASB) sets rules that affect how public companies are audited.  Loose FASB standards were one of the roots of the major accounting fraud that we learned of through the Enron scandal in 2001.  Yesterday, Bloomberg reported:

"The Financial Accounting Standards Board, pressured by U.S. lawmakers and financial companies, voted to relax fair-value accounting rules that Citigroup Inc. and Wells Fargo & Co. say don’t work when markets are inactive.

"Changes to fair-value, or mark-to-market accounting, approved by FASB today allow companies to use “significant” judgment in gauging prices of some investments on their books, including mortgage-backed securities. Analysts say the measure may reduce banks’ writedowns and boost net income. Firms could apply the changes to first-quarter results."

In other words, struggling financial institutions can now pretend (in their first quarterly reports for 2009, no less) that their assets are worth more than they really are.

This means that financial institutions can now pretend that their profits are higher (or losses are lower) than they really are.

What might be some of the consequences?  Financial institutions' stock prices may go up -- despite the fact that the real current value of their assets has not gone up.

This will make those of us who hold stocks in financial institutions happy. If stocks go up, I'll make money, because I bought stocks at garage-sale prices (though I'm a small shareholder).

FASB's allowing companies to create the appearance of higher profits (or lower losses) will likely make executives and managers at financial institutions happy, as they'll have grounds (albeit false grounds) to argue for bigger bonuses -- which will come out of the shareholders' pockets.

Despite the fact that I'll likely benefit from the new FASB rules, I have to call it as I see it: this looks like smoke and mirrors to me, like a government-encouraged sham.  I'm not alone.

Buried in the last half of Bloomberg's article are comments from former SEC chairman Arthur Levitt: arguably our nation's best SEC head in the sense that he was truly interested in protecting us ordinary investors (so that we could avoid having to dumpster dive to feed ourselves in our golden years):

"Fair-value 'provides the kind of transparency essential to restoring public confidence in U.S. markets,' former Securities and Exchange Commission Chairman Arthur Levitt said in an interview yesterday.

"Levitt is co-chairman, along with former SEC head William Donaldson, of the Investors’ Working Group, a non-partisan panel formed to recommend improvements to financial regulation.

“'The group is deeply concerned about the apparent FASB succumbing to political pressures,' he said."

Bloomberg picked a pretty mild comment from Mr. Levitt.  Here's some of what Levitt wrote in a Washington Post op-ed last week:

"[L]ast week, the FASB voted to propose allowing banks to obscure -- some might say bury -- the full extent of impairments on many of the bad loans and investments they made and securitized over the past few years. These impairments have traditionally been valued at market prices (thus, the phrase "mark-to-market"), so that investors can know what the banks would stand to lose if those investments were sold today.

"The FASB's proposal goes against what we know investors prefer: Stronger rules for the reporting of changes in the values of investments in income statements. Under the proposed rule, no matter how toxic the investment, whether it's a penny stock or the bonds of a government ward such as AIG, companies can choose to largely ignore the fundamental reasons behind the investments' decline. All that companies have to do is say they don't intend to sell those investments until their value rebounds.

"Such a subjective judgment is bound to decrease investor confidence in reported income. And in a strange twist of fate, the FASB's proposals may create even greater opportunities for short sellers who are adept at digging into numbers that do not tell the whole story.

"Yet the real scandal here is not the decision by the FASB -- with which I strongly disagree but which others might be able to defend. Rather, it is how the independence of regulators and standard-setters is being threatened. This isn't just about the income statements of banks. It's about further eroding investor confidence, precisely at a moment when investors are practically screaming for more protection....

"Investors once believed that U.S. markets were sufficiently protected from political pressure and manipulation by a system of interlocking independent agencies and rule-making bodies -- some government-run, some not. That system is being dismantled, piece by piece, by political jawboning and rushed rule rewrites. Now, investors find themselves with fewer protections and weakened protectors."

Think about that when you mull over your own stock investments, mutual funds, and 401k.

Andrew Sullivan titled his post about the new FASB rule "What the Hell Just Happened on Wall Street?" (a lot said in a few words).   Sullivan included in his post this comment from a reader:

"The traders just got a big rock of crack. This is called a bear market bubble, and it's going to do damage. The fact that stocks still went up significantly in spite of rather horrifying unemployment numbers coming out the same day tells you: a big rock of crack."

It seems to me that the falsely inflated company assets contributed heavily to our nation's current financial crises.

If that's the case, then why would public officials allow even more false inflation of assets -- and how would doing so help our economy in the long run?

Memeorandum has commentary.

Other Buck Naked Politics Posts:

* 663,000 Jobs Lost in March, Unemployment up to 8.5% 

* Real Executive Bonuses Based on Fake Profits

* More Right Wing False Analogies: this Time re: Executive Pay Caps

* PBGC Recklessly Invested in Pension Insurance Funds in Stocks

* Bank Execs Might Give Back TARP $ if They Can't Keep Bonuses

* Wall Street Execs Got Billions While Driving Economy Toward Cliff

* Executives Skate out of Economic Disaster with Millions

.

Comments

[Charles]

Here's the counterargument. Suppose that Ed's Fish has a truckload of fish purchased for $10,000 which Ed expects to sell for $20,000 in Indiana. On the road, his truck runs out of gas. How much is the fish worth?

A truckload of fish out in the middle of nowhere and going nowhere is worth zero. But if Ed gets some gas, suddenly it's worth $20,000, less the cost of the gas. The role of the market is to estimate how likely it is that Ed will get gas before the fish goes bad.

But realistically, it's not possible for the market to make that judgment. A good Samaritan could stop. Ed might offer to pay a premium for gas. Ed might open a fishstand by the highway.

A similar situation obtains with much of the dubious paper that's out there. 90% of mortgages are paying. There's no reason that simple CMOs should be written down by more than 10%. CDOs get more complicated. Those that were based on interest only are probably worthless. Those that were written on principal only are probably worth near face value. If we could get the secondary mortgage market functioning again, the value would rise... even though nothing happened to change the fish... er, mortgages.

The market is not magical. Marking to market makes sense in normal times, but serves only the speculators in times of market failure.

[Deb]

Charles,

I don't know about that, because I don't know the actual rules for marking to market. Presumably, the market was in "normal" times in 2007+, when firms started recalculating the value of their mortgage-backed securities.

If these firms had their way, I suspect that they'd use their discretion to use values from bubble days as a basis for valuing their assets.

Also, I'm not sure that the market has actually failed. It seems to me that it's adjusting for the fact that so many firms' assets were falsely (and overly) valued a couple years back.

[Charles]

If the market were functioning, Deb, assets would clear though at a low price. By definition, it is not functioning because prospective sellers believe that assets are worth more than buyers are willing to pay. Mark-to-market would essentially force the seller to accept the buyer's offer.

FAS 157 is at http://www.fasb.org/st/summary/stsum157.shtml

[Penny Stocks]

Great idea! i’m going to give your plugin a shot.

[Penny Stocks]

Very good and useful things that you have written in your blog.

[Penny Stocks]

Thank you for this informative post, I really appreciate sharing this great post. Keep up your work.