In the face of a financial crisis fueled by widespread overvaluation of real estate and mortgage-backed assets, investment banks and other financial sector interests have successfully lobbied to undermine accounting rules that ensure the integrity of asset valuations.
Bowing to intense lobbying efforts, in April of this year the Financial Accounting Standards Board (FASB) altered long-standing rules requiring banks to use "mark to market" accounting-that is, to value assets at what they would fetch in the current market. These changes permit companies to use inflated asset values and allowing companies to avoid having to recognize asset losses in reporting their earnings.
Investors should pay special attention to changes in FASB Staff Position 157-4, called Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly.In FSP 157-4, the FASB states that "[f]air value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction (that is, not a forced liquidation, or distressed sale) between market participants at the measurement date under current market conditions."
However, amendments to FSP 157-4 contain a loophole permitting companies to disregard an observable market price for assets traded in an "inactive" market-that is, a market in which there is little or no data about current trading values. When markets are inactive, the new rule empowers companies to exercise their own judgment in estimating the fair value of assets traded on inactive markets.
This development is dangerous because companies have the power to ensure that markets are inactive by ceasing to sell or buy risky assets-permitting them to value the assets using their own estimates rather than market prices.