Thursday, April 2, 2009

The Meaning of Fair Value Accounting

On September 15, 2006, the Financial Accounting Standards Board (the body responsible for establishing corporate accounting rules for the U.S. stock markets) adopted Statement 157, a set of rules concerning the determination of the "fair" value of an asset. This is the rule that governs the way many assets are valued, including the financial instruments that have turned toxic in the last two years. That day, the Dow Jones Industrial Average closed at 11,560.77, up 33.38 from the previous day. It achieved an intraday high of 11,661.38, or 133.99 above the previous day's close. By all indications, the stock market approved of Statement 157's impact on fair value accounting.

Today, under severe pressure from various members of Congress from both parties, the FASB issued interpretive guidance that appeared to give financial institutions more flexibility in the way they applied the fair value rules. In effect, banks were given greater latitude to avoid writedowns on assets not traded in active markets, including many toxic assets. The Dow closed at 7978.08, up 216.48. It reached an intraday high of 8,075.73, or 314.13 above the previous day's close. By all indications, the stock market approved of the rolling back of the stringency of fair value rules.

There are several conclusions one can draw: (a) the stock market is wrong at least half the time; (b) the stock market has no idea what's going on; (c) the stock market is, at the moment, manic; and (d) the stock market didn't understand the full implications of the initial adoption of Statement 157, but now has a better understanding. The correct conclusion is all of the foregoing.

Statement 157 was adopted at a time of ballooning asset values. Few people anticipated the real estate downturn, credit crunch and grizzly bear market we have today. Those that did were regarded as freeze-dried food and bottled water stockpiling Chicken Littles. Accounting rules rarely come into controversy during good times because rising asset values allow a company to look good even if the rules are stringent.

But falling asset values have the potential to expose a multitude of sins. As the financial system and economy fell on hard times, banks began to cringe over the need to mark assets down. It's easier to blame an accounting rule than writing assets down and recapitalizing a crippled bank. No bank executive was ever fired for blaming an accounting rule; nor was one ever fired for using political influence to get an accounting rule relaxed.

It's unclear whether today's interpretive changes will have the positive impact that investors seem to expect. Citigroup has already announced that it won't change its accounting even with the FASB's new guidance. To the extent that banks use the new guidance to paint a rosier picture of themselves, they may only be delaying the pain if the real estate market and economy don't rebound fairly soon. Accounting rule changes don't improve a homeowner's chances of meeting the rising payments on an adjustable rate mortgage. A laid-off worker doesn't get any more cash with which to cover monthly payments if the FASB relaxes Statement 157. Smart investors won't invest new capital in a crippled bank just because the bank has taken advantage of liberalized accounting rules to freshen up its makeup. Indeed, doing so may heighten investor suspicions that the bank's assets have a serious mold problem.

The FASB's action today may help the stock market continue a near-term rise. But if you want to know if the market has truly bottomed out and that long term recovery has commenced, look beyond the pronouncements of accounting authorities.

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