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Undermining Accounting Rules

by Michael W. Stocker and Craig A. Martin
Investment Week |
What are the Financial Accounting Standards Board's recent rule changes and what are their implications and potential risks for investors?

 <p>In the aftermath of a crisis spawned by staggering overvaluations in the markets for real estate and mortgage-backed assets, investment banks have arrived at a novel approach for dealing with similar crises in the future. In Europe and the US, industry interests have successfully campaigned to undermine fair value accounting rules that require banks to provide current and accurate assessments of asset values. In a recent report, the Financial Crisis Advisory Group (FCAG), an international panel consisting of leaders in business and finance policy, raises an alarm regarding these rule changes that investors would be wise to listen to.

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<br />The financial sector has long had a love/hate relationship with fair value accounting, the principle that assets should be marked to the prices they would fetch in the current market. When markets skyrocketed in the boom of the last 10 years, investment banks lauded the rule because it let them value the assets they held at their newly inflated prices. However, when asset prices began to collapse in 2007, the firms began to see the same rule as a problem.

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<br />As the financial crisis gathered momentum, financial institutions called for a suspension of mark-to-market accounting, insisting this rule was partly responsible for the economic problems. Banks argued that it was unfair to force them to recognize assets at current values when they intended to keep the instruments on their books for a long time. In the US, groups representing their interests aggressively lobbied the Financial Accounting Standards Board (FASB), an ostensibly independent authority, to relax the mark-to-market accounting rules.

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<br />However, proponents of mark-to-market accounting, including auditors, investors and financial analysts, contended that mark-to-market accounting contributed little if at all to the financial crisis. In fact, they argued, mark-to-market accounting increases transparency in financial statements and reinforces investor confidence.In a December 30, 2008 report to Congress on mark-to-market accounting, the Securities and Exchange Commission (SEC) agreed with these arguments and recommended against the suspension of mark-to-market accounting.

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<br />Despite the SEC&#39;s recommendations, financial sector lobbyists successfully persuaded American legislators to demand that the FASB change the mark-to-market accounting rules. In a March 2009 hearing, members of the House Financial Services Subcommittee confronted Robert Herz, the FASB chairman, and threatened to eliminate FASB&#39;s rule making rule authority if it failed to address the issue of mark-to-market accounting.Under duress, the FASB submitted proposed changes to the mark-to-market accounting rules just four days later. Three weeks later, the FASB formally amended the mark-to-market accounting rules.

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<br />The amended rules issued by FASB on April 9, 2009 are illustrative of the sweeping nature of the changes. The new FSP 157-4 contains a loophole enabling companies to disregard an observable market price for assets traded in an inactive market - in essence, a market in which there is little or no data about current trading values. When markets are inactive, the rule empowers companies to exercise their own judgment in estimating the fair value of assets traded on inactive markets.

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<br />This loophole permits a world of mischief: if financial institutions determine that asset values have declined embarrassingly, they can simply avoid selling them - creating inactive market conditions that permit the institutions to use their own inflated values instead.Worse, the FASB simultaneously issued new rules that allow companies to avoid having to recognize asset losses in reporting their earnings.

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<br />European accounting rule-making bodies fared no better. Even before the FASB rule changes, the International Accounting Standards Boards (IASB), FASB&#39;s sister organization in Europe, faced intense pressure from political leaders to make it easier for financial institutions to avoid recognizing losses on assets. The IASB chairman has acknowledged that, as a result, the IASB bypassed its normal due process to allow reclassification of some loans as a way of avoiding mark-to-market related losses.

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<br />The accounting changes in the EU and the U.S.will affect financial statements in at least two ways: risky assets be assigned higher values, and impairment losses recorded in earnings will significantly decline. The potential financial impact of the new mark-to-market accounting rules are evident in Freddie Mac&#39;s first quarter 2009 earnings.The new accounting rules in the US allowed Freddie Mac to avoid recording $1.3bn in fair value-related losses and potentially understated Freddie Mac&#39;s net loss had prior accounting mark-to-market accounting conventions been applied.

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<br />The FCAG, which advises the IASB and FASB regarding reforms related to the financial crisis, has expressed great alarm over the rule changes in the EU and the US. In a 2009 report concerning financial reporting and standards setting, the FCAG expressed concern over "the excessive pressure placed on the two boards to make rapid, piecemeal, uncoordinated and prescribed changes to standards, outside of their normal due process procedures" over the last several months. It further notes: "Both instances occurred under pressure that political bodies would make their own changes to the accounting standards absent swift action by the boards" and "while it is appropriate for public authorities to voice their concerns and give input to standard setters, in doing so they should not seek to prescribe specific standard-setting outcomes."

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<br />Investors would be wise to closely scrutinize not only the fair value accounting rule changes, but the manner in which political pressure has thwarted transparency and accountability in the markets.</p>