29 September 2008

'A Brief Education On The Subject Of Financial Reporting'

Like Matt P., I've heard a lot of people blame "mark to market" and other financial reporting issues for part of the current crisis. I've only taken one accounting class and my brother helped me get through that one. Fortunately, I've got lots of friends with degrees in accounting and one of them (the aforementioned Matt P.) wrote the following for our benefit:
I heard a talk show host blaming "arcane accounting policies" this morning for part of the crisis. I later heard that Rush jumped all over that yesterday as well. Knowing a little bit about the subject of accounting, I sent an email off to one of the hosts. While it is a minor hiccup in the entire financial episode, if you would like to have a brief education on the subject of financial reporting, below is a copy of the email that I sent.

It amazes me that you and other talk show hosts have picked up the newest talking point of the financial "crisis" being exaggerated or even caused in part by the "mark-to-market" accounting, as you call it. As a student of accounting, an employee of an "evil" international accounting firm and having been involved with the financial statement presentation of reputable companies such as CONSOL Energy and UPMC, I feel that I have some limited authority to talk on the subject. I'll admit that accounting standards are far from perfect; however, to blame the marking-to-market of securities as one of the reasons for the crisis is akin to blaming speculators for the spiking oil prices in that it is simply the manifestation of problems that have already or are expected to occur.

Here are a couple of items to think about:

(1) What is the alternative to the "mark-to-market" method of accounting for securities? If accounting principles stated that equity securities should be held at a historical cost, people would be out there berating the accounting world for not telling them what was happening. So we say, "The value of these securities can be reasonably estimated through open market transactions. So let's look at the prices for which they are selling on the exchanges." We went to the open market that says that the securities held by these companies are near worthless. What other basis can you give me that I could reasonably use as a value other than (a) historical cost (which would lead to complaints) or (b) open market transactions (which apparently has led to complaints)?

(2) What about the potential value of the assets behind the securities? Although the market is deciding the value based on the perceived potential value of the assets behind the securities, let's discuss. Contrary to what it seemed you were indicating this morning (admittedly, I was unable to hear the entire segment), the potential value of the assets has no valid basis in accounting. Can you imagine the trouble and liability any firm would take on if it decided to value its assets at the "potential" value? Say I have an old machine sitting in the back that has the potential to produce $10 million in garden gnomes a year. Does that mean I have a multi-million dollar asset that I should have on my books? Not if I can only sell the asset for $1 million and there is no current demand for garden gnomes.

Well, there are millions upon millions upon millions of mortgage-backed securities out there. There's a chance that you could dissolve the securities and sell off the mortgages or properties and get more than what the market says the securities are worth. Sounds like an opportunity for an investor to me, but I'm not going to stake my reputation for faithful representation on a chance. That investor will still be purchasing the security at market prices, which tells me that the market price is all that this security is worth to that firm holding it.

(3) What is it that accounting is really supposed to accomplish? Accounting standards as you are discussing, related to external financial reporting, are a basis for presenting historical (not even real time, let alone future) information. The best public companies still take a number of weeks to pull together full financial statements with a few more weeks of auditing before being able to file with the SEC.

One also needs to realize - as anyone who has taken basic accounting 101 should know - that these investments are held on the balance sheet, which is a snapshot at a point of time, attempting to faithfully represent the assets, liabilities and equity of a firm as of a specific date (see #2). As a result, this is simply a reflection of what the market is thinking now. If the market changes its mind tomorrow resulting in an increase in the value of mortgage-backed securities, then companies would be back in business, right? Take another snapshot and see where it puts you.

At the end of the day a number of companies (upon whom the responsibility lies - along with Washington politicians) made poor operational decisions. To blame the way that accounting rules display the results of these poor decisions is to shoot the messenger and take focus away from where true responsibility lies.

Please don't just jump on the bandwagon.
Thanks to Matt P.

If you have tips, questions, comments or suggestions, email me at lybberty@gmail.com.