According to the WSJ, the Financial Accounting Standards Board (FASB) is changing its mark-to-market rules tomorrow, "allowing banks to set their own values for certain hard-to-value troubled mortgages, corporate loans and consumer loans...The change was meant to assist U.S. banks after bankers complained current mark-to-market accounting rules forced them to undervalue their assets, by setting prices at deeply discounted, fire-sale values."
The most alarming part of the article is the observation that there is a "disconnect" between this accounting change and the Treasury Plan for banks. Both try to address the central problem of valuing so-called
toxic assets legacy funds. Everyone seems to believe that these assets are "really" worth more than they're selling for now, and therefore that anyone who sells now is losing money they don't have to, because at least some will increase in value.
What do we want banks to do? Hunker down until the storm passes and the assets can be sold for more money than they can get now? If so, and banks are hindered by an accounting rule that forces them to "mark" them down to an artificially low "market" price, then FASB's change of heart could help them eventually see more money. But if we want banks to get rid of these assets, then Treasury's Public-Private Investment Fund (PPIF) could help banks. But then PPIF investors and taxpayers would get the benefit from the expected up-tick in value.
I favor the PPIF idea, on the theory that relaxing mark-to-market gives banks an incentive to "wait it out," rather than deal with the central problem of valuation and facing up to losses. Still, I'd hate to have sell anything--a house, a car, a teacher's manual--in this market. Actually, if you're looking for that last one...
The SEC has now chargedFriehling & Horowitz, P.C. with securities fraud in connection with acting as auditor for Bernard Madoff Investment Securities LLC. Press release here.
Whatever this accounting firm did since 1991, it didn't seem to audit anything in connection with BMIS. I can't even imagine a defense that the firm would have in a situation in which it signed off on financial statements that were completely fabricated. In the words of the press release: "Friehling essentially sold his license to Madoff for more than 17 years."
Early reports of accounting fraud at Indian outsourcing giant Satyam Computer Services sound eerily familiar:
The final blow came in the past few days. The lenders who had loaned money to Mr. Raju to keep the company running began to sell the pledged shares to meet margin calls, or the forced selling of shares to cover losses.
The leader for the WSJ:
The chairman of one of India's largest information technology companies admitted he concocted key financial results including a fictitious cash balance of more than $1 billion.10 years ago I was a lowly paralegal, fresh from an abortive career in literature, working on a securities class action against a California chip-maker. I had always thought business was mysterious and impenetrable, and that financial fraud must be sophisticated beyond my ken. It was a revelation that smart, powerful businesspeople occassionally decide that it's a good idea to make numbers up, trusting that "gaps" will close and everything will turn out okay in the end. I may be naive, or even gullible, but my reaction is still, "You really thought no one was going to notice? A billion dollars? Really?"
We've told you that valuing assets ain't easy these days. Indeed, "these the times that try one's sells" (love that line). Bainbridge thinks that the SEC advice on mark to market flexibility doesn't do anything. Larry Cunningham thinks it could, but it's a novel use of accountancy. Ribstein thinks it is corrupt, John Carney thinks it requires guessing how the government will price the assets, and well-known short James Chanos says that valuation flexibility will just mean that the banks overprice them more.
The SEC revisited its fair value accounting standards today, as Usha predicted. Here's the SEC statement, and Floyd Norris has insights here and here. We speculated that the bailout would eventually take a criminal tinge, Doug Berman agrees.
Since the collapse of Bailout 1.0, I've been wondering when critics would seize on mark-to-market accounting. It turns out that Newt Gingrich and Mark Cuban (never thought I'd use those two names in the same sentence) have been calling for a suspension of the rule. From Newt:
Mark-to-market accounting (also known as "fair value" accounting) means that companies must value the assets on their balance sheets based on the latest market indicators of the price that those assets could be sold for immediately. Under such a rule, declining housing prices don't just reduce the value of defaulting mortgages. They reduce the value of all mortgages and all mortgage-related securities because the housing collateral protecting them is worth less.
Moreover, when a company in financial distress begins fire sales of its assets to raise capital to meet regulatory requirements, the market-bottom prices it sells out for become the new standard for the valuation of all similar securities held by other companies under mark-to-market. This has begun a downward death spiral for financial companies large and small.
More foreclosures and home auctions continue to depress housing prices, further reducing the value of all mortgage-related securities. As capital values decline, firms must scramble to maintain the capital required by regulation. When they try to sell assets to raise that capital, the market values of those assets are driven down further. Under mark-to-market, the company must then mark down the value of all of its assets even more.
I'm not a tax gal. Anyone care to weigh in on this one? I know mark-to-market was the response to accounting hanky panky at Enron, WorldCom, et al. Was the cure worse than the disease?
Do you know that acronym? If not, you need to learn it. Moving the US toward the International Financial Reporting Standards will be a top priority of the new SEC commissioners -- including Troy Paredes -- once they are confirmed later this year. The Senate Committee on Banking held hearings on the new commissioners on Tuesday, and Chairman Dodd gave the right signals for confirmation: "I want to get people in place and start making decisions. Too much is at stake with this housing mortgage crisis, the economic crisis.... The SEC needs to function. We've got some huge issues out there."
The SEC hasn't abandoned its ever faltering mutual recognition efforts for foreign regulators and the markets they supervise. The last time it tried this seriously, the agency only got as far as Canada - sorta. But perhaps globalization - and the new impetus to harmonize accounting standards - will prove more inspiring this time. Here is the SEC's plan going forward:
The Commission contemplates taking the following actions:
- Exploring initial
agreements with one or more foreign regulatory counterparts, which
would be based upon a comparability assessment by the SEC and by the
foreign authority of one another's regulatory regimes.
- Considering adoption of a formal process for engaging other national regulators on the subject of mutual recognition. This process could be accomplished through rulemaking or other appropriate mechanisms, possibly informed by one or more initial agreements with other regulators.
- Developing a framework for mutual recognition discussions with
jurisdictions comprising multiple securities regulators tied together
by a common legal framework, including Canada (which has no national
securities regulator, but rather provincial regulators) and the
European Union (whose national securities regulators are subject to
supranational legislation and directives).
- Proposing reforms to Rule 15a-6 in order to improve the process by which U.S. investors have access to foreign broker-dealers.
Eat your heart out, Larry! I am sitting in a room filled with accountants at the BYU Accounting Research Symposium. The presenters are mostly doctoral students and new faculty, and one of the express purposes of the symposium is to provide feedback on early-stage work, so I won't blog about any particular projects.
Two quick observatons. First, though I was an accounting major as an undergraduate at BYU, this is my first academic accounting conference of any kind, and though the nature of this gathering is unusual because of its focus on work by newbies, I am pleasantly surprised by the level of audience participation. Lots of comments and questions. This must be a great help for the presenters.
Second, lots of law-talk in the papers and presentations. SOX, Reg FD, and other securities regulations of all kinds have a prominent place here. Very easy entry for an securities professor with some knowledge of accounting.
P.S. Former Conglomerate guest blogger Darren Roulstone is sitting nearby and is an active participant in the discussion. He is obviously a rock star here, no doubt because of his guest blogging.
FASB, the US accounting standard setter, has long protected its brand name, including by asserting copyright over its US GAAP standards and selling them for profit. In contrast, IASB, its international counterpart, although also asserting copyright over its international financial reporting standards, gives its products away free to all persons within any country that recognizes IFRS as official. Why this strategy? One possibility is to promote adoption. If so, it has worked: some 100 countries already recognize IFRS.
But what effect does the give-away program have on the signaling value of adopting IFRS? For signaling to work, adoption must carry a cost higher than low-quality users would pay. But it is essentially costless for countries to adopt IFRS and let IASB bear all associated costs—the giveaway program makes it even more cost-effective. Other aspects of the debate on IFRS quality and enforceability aside, what effect will IASB’s marketing triumph have on the credibility of its ultimate product?
In proposing to let non-US companies report in IFRS (international financial reporting standards) without reconciling to US GAAP, and seeking comments on letting US companies choose which to use, the SEC made a tactical choice: it justifies both moves in the name of promoting global uniformity. This is a curious decision.
Hardly any serious, informed person actually expects people in all the different parts of the world to answer hard accounting judgments the same way, even if all apply the same written standards. So the SEC’s premise looks wrong as a practical matter.
In reality, the moves would open the possibility of head-to-head competition between FASB, the US standard-setter, and IASB, promulgator of IFRS. That may be appealing, at least for devotees of regulatory competition. Let more standard setters bloom. Let companies choose from the resulting garden of standards.
Is the SEC calculating that it will garner more support for its proposals in the name of “global uniformity” than it would in the name of “global competition”? How does this calculation square with the likelihood that discord, not harmony, is the more likely result?
A political storm is settling down over how much effort auditors should make when testing financial report reliability. Sarbanes-Oxley created the Public Company Accounting Oversight Board (PCAOB) and told it to have auditors test and report on a company's internal controls as a way to infer how reliable its financial statements are. Under PCAOB's first standard (2004), managers protested that auditors were asking too much at too great a cost. The SEC intervened to address this criticism by getting PCAOB to withdraw its original standard and replace it with a new one, which the SEC approved this summer. How do the two compare?
The original: (1) required auditors to do their own tests of controls, tell investors of any discovered problems, and explain their meaning for financial statement reliability; (2) said auditors had to disclose issues posing more than remote risks of misstatements; (3) let auditors choose what framework to use for the tests; (4) made both quantitative and qualitative problems relevant; and (5) told auditors how to evaluate audit committees.
The new version: (1) lets auditors rely on management for much of the testing and defer to management's report to investors about any problems; (2) gives investors only information about problems posing a "reasonable possibility" of misstatements; (3) lets management chooses what framework to use and requires auditors to follow management's choice; (4) scraps any notion of qualitative importance; and (5) throws out guidance on how to assess audit committees.
Proponents of the new version say it is more efficient by lowering costs of this exercise. Critics say audit quality, not efficiency, should guide evaluation of controls and financial statement reliability. Some defend the new standard by denying that it deviates from the original in substance, saying it is better because it uses "principles" not "rules." By this they mean it gives auditors and managers flexibility rather than spelling out what is required in detail.
The jury will be out on the merits for quite some time. We know that the original generated significant costs and can be fairly certain from the changes that the new version will cost less. Between the standards, the pendulum swung from one extreme toward the other. The unknown is whether it is now in the right place. We will only know that after the next wave of financial reporting fiascos occurs and is diagnosed. But you can be sure the diagnosis will focus on the quality of internal control.
Accounting firms may face catastrophic liability if they
certify the returns give unqualified audit opinions before another Enron-style collapse. And yet we don't have many big accounting firms left, and perhaps we would prefer not to lose another. What to do? Cap auditor liability? Insure? Seek ex-post bailouts? Larry Cunningham proposes that the accountancies issue catastrophe bonds in this paper, and debates the issue with Kevin LaCroix of the D&O Diary here ( permalink apparently unavailable UPDATE: link also here). A taste, and please excuse the occasional brackets where I added explanatory materials - all errors mine:
Reducing [catastrophic] risk by putting legal caps on auditor damages is a hard political sell—Members of Congress find it difficult explaining to American investors why these firms should enjoy such a privilege and any choice of cap levels could seem arbitrary....
I consider cat bonds because they: (a) could add resources to meet claims that threaten to destroy audit firms or the industry; (b) avoid political obstacles facing both caps and financial statement insurance; and (c) highlight informational problems in the policy debate on caps....
[I]t is possible to see informational problems [about the nature of the risk for accountancies] as a sort of market failure supporting regulatory intervention. Yet the information is within firms’ control and they can decide whether to use it in the political arena, in markets, or not at all. Notably, using this data [necessary to assess the risks of significant auditor liability] in the political arena to support caps creates incentives to overstate risk whereas using it in the marketplace to sell cat bonds creates incentives to understate risk
[T]he whole value of a capital market based solution [like cat bonds] is to avoid the cyclicality and volatility of the insurance marketplace, but the capital markets for these kinds of bonds could be subject to the own cyclicality. Indeed, during a time of significant losses, there may be little or no market interest in bonds of this kind, just as when insurer losses mount insurance can be scarce or unavailable. For that reason, I am uncertain whether the availability of this type of capital market alternative, even if the other barriers could overcome, would in the end remedy the concerns for which an alternative to the traditional insurance marketplace was sought.
As they say, both check it out and download it while it is hot.