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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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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French Banks Argue Against Basel III Mark-to-Market Requirements
The French Banking Federation (FBF), which includes French banks BNP Paribas, Sociètè Gènèrale and Crèdit Agricole, pushed for loosening proposed requirements for Euro-zone banks including mark-to-market valuation requirements.
A French study estimates that European banks would need to raise 360 billion Euros ($503.3 billion) to offset the core capital deficit that the requirements would create. It also estimates that there is a shortage of stable funding of between 2 and 3.5 trillion Euros.
In an April 16 letter to the Basel Committee on Banking Supervision responding to Basel III proposals FBF Director-General Delegate Pierre de Lauzun writes, “Excessive capital and liquidity requirements would bring the economic recovery to a screeching halt.”
Among European banks the French are unusually exposed to stricter rules on capital because of cross-shareholdings rules.
Baudouin Prot, BNP Paribas Chief Executive and head of the FBF, has suggested that a new round of talks on these proposals be held later this year.
Mark-to-market accounting is destructive to capital, pro-cyclical and impractical. Let’s just disclose marks and let the market decide. Bad firms would go out of business and good ones would thrive (assuming we stop all of this TBTF and bailout nonsense).
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Accounting Issues “Untouched” by Financial Regulatory Reform Bill
William Isaac, a former Federal Deposit Insurance Corp. chairman and now the chairman of LECG, expressed his objections to the Financial Regulatory Reform Bill now being debated in Congress. He is quoted in American Banker as saying that, among other omissions, “What’s wrong with these bills is they do not fix the regulatory system that led us into this problem…They don’t deal with the accounting at all. Mark-to-market accounting was a major contributor to this crisis.”
Other critics argue that rules governing banks have actually been softened by the changes in mark-to-market accounting. Banks are now free to “write-up” the values of assets that had few, if any, buyers.
Mr. Issac also notes that the bill does not deal with the Basel capital accords and the procyclical accounting for loan-loss reserves. Nor does the bill institute an independent watchdog to oversee the system.
What’s the rush? Let’s do it right. The economy seems to be getting better. Let’s find a solution that works, rather than one that is easy to pass through Congress now…remember the old saying, “Decide in haste, repent at leisure.”
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BOE — Suspending Mark to Market is “Moral Hazard”
Adam Posen, member of the Bank of England’s (BOE) monetary policy-setting committee, responded to a question from a Dallas audience, “If you have mark-to-market only suspended on the downside, you have the mother of moral hazard.” The question to which he was responding was whether the requirement for fair-value accounting exaggerated the recent financial crisis.
Mr. Posen was speaking at a conference on the euro. He also claimed that suspending mark to market was an invitation to “accounting games,” and that “The lesson from history is, avoiding mark to market tends to make things worse.”
Mr. Posen is an American and a former deputy director and senior fellow at the Peterson Institute for International Economics in Washington. He has also been an economist at the U.S. Federal Reserve Bank of New York and he has worked with the European Central Bank as well as the BOE. In 1999 he co-authored a book on inflation targeting with Federal Reserve Bank Chairman Ben Bernanke.
Posen’s right. If you have mark-to-market, it should go both ways. But it is aimed at the wrong target. Lack of capital and liquidity caused the run on the credit markets. Too much leverage. Let’s fix this first.
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