Investment giant Goldman Sachs has been questioned for its hedging practices after posting massive third quarter gains after generally dismal results for the past few quarters. The reason for Goldman and others’ gains is due to an accounting rule “that has the counterintuitive result of increasing reported profits – and revenues – just because people are losing faith in the ability of the bank to meet its obligations,” says Norris.

The rule creating the confusion is the fair value rule, says Norris. The rule is voluntary, meaning that banks can choose whether or not to apply the rule and – within reason – pick and choose which assets and liabilities to apply the rule.

Pressure from the financial crisis allowed banks more leverage to shift Financial Accounting Standards Board (FASB) principles their way. “We are moving back to the past,” says former FASB board member Ed Trott.

The IASB rule was put in place after political pressure during the financial crisis prompted hasty action at the international accounting rules-setting body. A move to tweak the rule has been expected since differences in opinion on the topic derailed “convergence” of standards with the United States-based Financial Accounting Standards Board (FASB). The convergence of standards between American and international accounting principles was initially set for June of 2011.

“If we are going to consider the FASB position and think what we should do and ask constituents’ views, then implicitly we have to contemplate the possibility of reopening IFRS 9 and making changes. Otherwise, what is the point of consulting?” Cooper said.

Noting that the FASB has been influential in dictating fair value standards, Cooper continued: “If FASB ends up in a different position…and if we want to achieve convergence then somebody has got to change. No decisions have been taken on this.”

The United States Securities and Exchange Commission will eventually make a ruling on whether or not to adopt IASB rules outright, hinging on the board’s fair value decision. The U.S. is the only major economy not using IASB.

Shifting certain reporting measures away from mark-to-market would mean that Goldman Sachs and Morgan Stanley would use historical cost accounting, valuing assets at their original purchase price rather than current market value.

The Wall Street Journal report on the potential shift said that only a small portion of the companies’ $1.7 trillion in combined assets would be affected.

Such a move is not guaranteed. As The Wall Street Journal reported, “there are wide differences of opinion among executives” of both companies. Should Goldman Sachs and Morgan Stanley decide to make the switch, no regulatory approval would be required, allowing for a swift transition if the companies’ leaderships so chose.

A 2008 change to classification as bank holding companies allows for less strict regulation in situations like these. It also allowed both companies to tap into the Federal Reserve’s emergency fund discount window during the financial crisis.

It’s the BASEL endorsement and encouragement of the holding of sovereign bonds as “ risk-free” that have lead to a lot of the pain in Europe. BASEL increased the holdings of risk-free sovereigns in the banks.

The SEC’s decision to delay the potential ruling is prudent and appropriate.

[$$] SEC Delays Call on Accounting Rules – The Wall Street Journal, December 6, 2011

The counter to this volatility is extreme caution in investment policy and a reliance on low-return government bonds, both methods drive up pension plan costs, says the NAPF’s report.

“The current standards are not appropriate for the long-term nature of pensions. They allow short-term stock market volatility to perversely affect pensions and their long-term strategy by presenting large deficits which may prove inaccurate in the long run,” says NAPF chairman Lindsay Tomlinson.

United Kingdom-based NAPF follows the direction of the International Accounting Standards Board (IASB) while the United States follows the Financial Accounting Standards Board (FASB).

The two governing bodies have attempted to merge standards recently, with mark-to-market accounting being the main hot-button issue. Some notable United States companies, including Verizon, Honeywell, and AT&T, have made the switch to mark-to-market valuation of their pension plans, partially as a prediction that the FASB will adopt the IASB’s mark-to-market standards.

The survey, which covered 134 Chief Financial Officers, Chief Compliance Officers, and valuation team members, showed an increasing attention to market volatility as it relates to fair value accounting procedures.

“The heightened level of volatility in the market draws attention to the importance of fair value practices for mutual funds investing in international equities,” said Rob Haddad, director of Evaluated Services for Interactive Data. Haddad continued, “Our survey found that mutual funds are generally well-prepared for volatile market scenarios, with predefined fair value procedures in place to handle such events, and formal back-testing processes to examine how these procedures worked in practice.”

Among mutual funds, 36% reported that fair value is being applied every day, up from only 10% in 2004. The other 64% of funds reported using “triggers” — a process that pays attention to market movements and benchmarks — to apply fair value procedures for the fund. The strategy for triggers varied greatly in method, scope, and complexity, said the study.

A newly popular method of valuation, CAPE relies on inflation-adjusted earnings statements as well as averaging 10 years of reported earnings to account for business cycle effects. Wilcox says that CAPE provides “an overly bearish view of the stock market” and should be used with caution.

Fair value accounting, says Wilcox, showed how a change in accounting regulations had a material impact on reported earnings and is a key flaw in Shiller’s CAPE method.

When the Financial Accounting Standards Board (FASB) issued the fair value ruling in 2006 (and up through the financial crisis in 2008), investment securities and mortgage-backed securities made up a significant percentage of banks’ assets. Wilcox says, “The move toward more fair value accounting standards resulted in security losses having a devastating effect on the reported earnings of financial institutions” in the fourth quarter of 2008. CAPE, says Wilcox, must continue to reflect the impact of a single quarter’s massive loss even though it’s unlikely it will happen again in the next 10 years.

Fair value accounting is one method that regulators have undertaken to improve transparency, requiring that assets be accounted for at market price (rather than purchase price) to give a more accurate view of a holding’s value to both insiders and outsiders of a company. But financial insiders point to increased volatility in financial statements, leading to unnecessary and unintended instability.

The more that a financial institution relies on short-term pricing and value changes, the more at-risk it is for a “feedback loop,” as “decisions of financial institutions are more likely to be based on second-guessing of their competitors than on perceived fundamentals,” says Sapra. “Put differently, in trying to enhance market discipline, reliance on market prices via fair-value accounting weakens market discipline,” he concludes.

Amen to that, Professor! Let’s do both–print holdings at purchase price and then footnote the exact mark-to-market effect. This attains both goals–it gives long-term decision-making room to think and operate and fully discloses the market value effects on the institution. Why isn’t this a perfect solution? It provides more disclosure and less volatility–win-win!

This had astounding effects, says Wright. “The Basel Committee on Banking Supervision has calculated that two-thirds of the losses made on derivatives during the credit crisis came not from the default of counterparties but from the deterioration in their credit quality,” he says. Standard & Poor’s believes that of all the Basel committee’s actions, this requirement has “the greatest potential implications for the behavior of financial institutions in the medium term.”

These new rules were necessary because prior regulations ignored potential mark-to-market losses, says Wright. It was the timing and complexity of FAS 157 – the 2007 mark-to-market requirement – that ultimately caused undue stress for financial institutions in the United States.

“Often the regulatory response to one crisis sets the parameters for the next, says Wright. “All those governments poised to push through new financial regulations in the coming months should examine the example of new counterparty credit risk rules…and ask themselves whether now is the best time to field-test their unproven ideas,” Wright concludes.

Mark-to-market accounting “has led to greater volatility in comprehensive income and the recognition of substantial and often volatile pension deficits in the statement of financial position,” said the study’s authors, Iain Clacher and Professor Peter Moizer. Mark-to-market has caused the decline in defined benefit plans “as corporate managers have increased the pace at which these schemes are closed to new members and to future accrual by existing members,” the authors continued.

In the United States, however, many pension plan administrators for large companies like Verizon and Honeywell have made the switch to mark-to-market for their pension plans. Analysts believe US companies have made the shift partially as a proactive move in the event that U.S. Generally Accepted Accounting Principles (GAAP) would begin to require mark-to-market in the near future. Many also point to the practice as a strategic move, allowing recession-hit pension plans to recognize losses in one year as opposed to smoothing losses over many years.

The ideal model, according to the study, would include the present value of future cash flows and cash payments by benefit plan administrators.