IASB Responds to Criticism Over Mark to Market Accounting
In response to criticism about the effects of fair value accounting, the International Accounting Standards Board (IASB) has made public its proposed changes to the accounting standard for financial liabilities.
Should the proposal be approved, all gains and losses resulting from changes in “own credit” for financial liabilities that an entity chooses to measure at fair value would be transferred to “other comprehensive income.”
“Whilst there are theoretical arguments for treating financial assets and liabilities in the same way, it is hard to defend the accounting as providing useful information when a company suffering deterioration in credit quality is able to book a corresponding large profit,” said Sir David Tweedie, Chairman of the IASB. “Especially when investors tell us that such information is often excluded from their financial models.”
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Silicon Economics Sues the FASB
Economics, Inc. (SEI) has filed a lawsuit in a federal district court against the U.S. Financial Accounting Standards Board (FASB), charging it with antitrust violations and willfully attempting to misappropriate patented technology belonging to the company. The suit concerns Silicon Economics’ EarningsPower Accounting™ (EPA) method, a solution designed to address the inadequacies of mark-to-market accounting.
SEI had submitted their EPA method in response to FASB’s request for public comment on the objectives of financial accounting. FASB had subsequently laid ownership claims to the technology, defending it as fair game under the terms disclosed on their website. SEI denies being informed of those rules.
“FASB’s unlawful attempt to appropriate SEI’s intellectual property undermines innovation and competition, and harms the U.S. economy,” said SEI’s Attorney Perry J. Narancic. “SEI will defend its intellectual property vigorously.”
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Three Problems, One Solution
Binod Shankar is a CFA Charterholder consultant who runs Genesis, a Dubai-based financial training company. Writing for The National, he observed three problems with mark to market accounting and offers one solution.
Problem 1: When there is a crisis, buyers stop buying and the market grinds to a halt. Hence there is no market value to which one can “mark.” This is particularly true for long-term assets that are difficult to value in normal times.
Problem 2: Any change in asset value, negative or positive, passes through the income statement without any cash flowing in. This impacts profits but doesn’t bring in any cash when they rise, nor is there a “real” loss when markets are down.
Problem 3: If a company has an income statement that is inflated with fair value assets, investors will want higher dividends. If fair value assets deflate the income statement, perfectly stable companies’ capitalization can become suspect. Hence mark to market accounting is highly misleading in good times as well as bad.
Solution: Binod Shankar recommends that all changes in fair value should be routed through the balance sheet instead of the income statement. Additionally, investments that are intended to be held to maturity should not be marked to market.
We agree.
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Mark-To-Market Impacts Pension Funds
It is anticipated that corporations would take less equity and other investment risk in their defined benefit plans if a revision the International Accounting Standards Board (IASB) is proposing for pension accounting is adopted. The IASB provision would require companies to immediately recognize gains and losses in their defined benefit plans on their income statements. These changes are now amortized over an extended period of years.
Caitlin Long, managing director and head of the pension solutions group of Morgan Stanley, New York, explains that the current amortization is “an incentive in GAAP (Generally Accepted Accounting Principles) to take more investment risk.”
Judy Schub, managing director of the Committee on Investment of Employee Benefit Assets, Bethesda, Md., was also quoted by Pension & Investments and she agrees. “The closer you get to mark-to-market (accounting) the more derisking you have in (pension fund) portfolios and the more expensive plans would be.”
The IASB proposal would bring market valuation of pension plan gains and losses to the income statement.
“We argue this whole trend is pushing plans away from a long-term focus, and the more you do that the more you undermine existing plans,” Schub said.
MTM for pension funds is backwards. Don’t we want our pension funds to be intended to take the “long-term” view?
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ECB Opposes Fair Value Accounting
Speaking at a conference in Paris, European Central Bank Executive Board member Gertrude Tumpel-Gugerell said that the U.S.-led move towards fully valuing assets at their current market value is in many ways misguided.
In her comments, she also stressed that policymakers should give greater mind to financial stability when designing new accounting standards. She also mentioned that she was not optimistic that America and international accounting standards could be blended into one worldwide standard by mid-2011.
In the notes of her speech given in Paris, Tumpel-Gugerell said “The ECB strongly opposes a full fair value approach … The potential impact of fair value accounting on behavior, asset price dynamics and subsequently on financial stability should not be underestimated.”
Fair value accounting was also problematic in illiquid markets, she argued. “What is the use of marking to market when there is no market?”
This is from Europeans! Aren’t they smarter than we are on everything? “…the potential impact of fair value accounting on behavior.” That says it all. Be careful what you wish for.
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FDIC Exposes Mark-To-Market Gaps
When taking over a failed bank the Federal Deposit Insurance Corporation (FDIC) reveals vital information about the current market value of an institution’s assets.
There is a significant gap between the FDIC estimated values to those calculated by bank management using mark-to-model accounting subsequent to the Financial Accounting Standards Board (FASB) suspension of fair value accounting in April 2009,
Among recent bank failings the FDIC using mark-to-market accounting valued assets between 96-125% lower then bank management using mark-to-model accounting.
There are no reports of alleged fraud or negligence on the part of management in these bank failings.
Maybe this describes two things: 1) Bad/misbehaving management and/or 2) Liquidation value vs. economic value. Nothing to report here.
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Broderick Credits Mark to Market for Goldman Sachs Success
In his prepared statement to the Senate Permanent Subcommittee on Investigations, Chief Risk Officer of Goldman Sachs Craig Broderick explained how Goldman Sachs believes in a rigorous mark-to-market value assessment.
The central tenet is our daily discipline of marking all of the firm’s financial assets and liabilities to current market levels. We do so because we believe it is one of the most effective tools for assessing and managing risk, providing the most transparent and realistic insight into our risk positions and associated exposures. Goldman Sachs is one of the few financial institutions in the world that carries virtually all financial instruments held in its inventory at current market value, with any changes reflected immediately in our risk management systems.
Chief executive Lloyd C. Blankfein foreshadowed Broderick’s remarks in his own opening statement, “We believe that strong, conservative risk management is fundamental and helps define Goldman Sachs.”
During the contentious session, Mr Broderick credited Goldman’s risk management and mark-to-market accounting for minimizing its CDO losses in 2007-08.
This is an appropriate application of MTM. MTM for trading firms only. MTM disclosure for investors/banks/insurance. The accounting for investors should be different for traders and broker/dealers.
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SEC Focuses on IASB Funding
Jim Kroeker, Chief Accountant of the U.S. Securities and Exchange Commission, says efforts are now focused on securing funding for the International Accounting Standards Board (IASB). The IASB writes the International Financial Reporting Standards (IFRS) that are used by more than 100 countries, which may soon include the U.S.
“A stable broad-based funding system with a diversity of capital market participants providing ‘no strings attached’ funding is of great importance to establishing a structurally sound international standards setter,” Mr. Kroeker said to an accounting conference at Baruch College in New York.
Mr. Kroeker’s comments come as political pressure on accounting rule-makers mounts worldwide. Last year, some in the European Union threatened to make their own changes to accounting rules if the IASB did not immediately adjust mark-to-market accounting rules.
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How Mark-to-Market Can Work For Derivatives
Kevin Cook, an options instructor for the Options News Network, argues that mark-to-market will work for derivatives. He suggests following the “LaSalle Street” model that has functioned smoothly in Chicago for over 160 years for the trading of commodity futures and financial exchanges. To begin trading derivatives on an open exchange he lists five criteria that need to be introduced:
1. Standardize size and terms of contracts so they can be traded freely and that risk transfer and price discovery are obvious.
2. A centralized clearinghouse must stand between buyers and sellers to ensure transparency and the enforcement of rules.
3. Twice daily mark-to-market would force risk management. This makes risk management a real-time, robust process, not an after-the-fact accounting guess.
4. Performance bond collateral is what every trader in Chicago must post, and it is a “good faith” deposit that is a volatility-based measure of the risk. It forces futures clearing member firms to mind the risk on all positions held in their customer accounts.
5. Liquidity and price discovery in an open market would make it possible for banks to avoid investing in illiquid assets.
Cook then closes his argument by citing the fact that over 160 years of futures trading history, no trading counterparty has ever lost money due to the failure of another.
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IASB and FASB at Impasse over Mark-to-Market Accounting
Mark-to-market accounting is proving to be a major sticking point in efforts to converge the world’s two most important accounting systems, Generally Acceptable Accounting Principles (GAAP) and International Financial Reporting Standards (IASB). In September, the “Group of 20” leading industrialized nations pledged to create a single global set of accounting rules by June 2011.
In a joint statement, the International Accounting Standards Board (IASB) and the U.S. Financial Accounting Standards Board (FASB) said that they had failed to reach an agreement on the valuation of financial instruments. They commented that there was “no guarantee” they would be able to resolve their differences and that it “could affect the project timetables.”
The FASB supports a more widespread use of mark to market accounting than the IASB.
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