One of the big controversies of the last week was the Federal Accounting Standards Board (FASB) changes to so called "mark-to-market" (M2M) accounting guidelines.
My understanding is that the FASB wanted to provide new guidelines to figure out fair values (of assets on Companies' balance sheets) when there is no active market or where the price inputs represent distressed sales - which we see a lot of today.
FASB seems to want asset prices on the books to represent what an asset could be sold for in today's markets in an "orderly transaction". The FASB put the onus on the reporting Companies to determine whether the observed prices or broker quotes represent "distressed transactions", and then report the price of their assets estimating the "orderly" selling price of the assets in the current market. To prove this, the FASB is requiring additional disclosure, but it seems very difficult to me to prove what "orderly" is. Kind of like knowing what is is.
Furthermore, there was another FASB proposal to deal with other-than-temporary impairment (OTTI). The new proposal the Board voted through indicates that no impairment charge is required if there is both no current intention to sell and, more likely than not, no requirement to sell prior to recovery, unless management expects at the balance sheet date that all of the cash flows won't be 100% collected. The proposal changes the presentation of the impairment charge, splitting it up into two pieces. First, the amount of the impairment related to adjust the credit losses will be reflected in earnings. Second, the amount of the impairment related to all other factors will be shown in other comprehensive income in the equity section of the balance sheet. There will be a "gross" presentation of this on the income statement, where one will be able to see the total fair value change, and then the amount offsetting it being applied to other comprehensive income. Tangible Common Equity should be relatively unaffected by this proposal, though earnings, other comprehensive income and retained earnings would be impacted.
Finally, the FASB voted that fair value disclosures should be required on a quarterly basis, providing qualitative and quantitative information about fair value estimates for all those financial instruments not measured on the balance sheet at fair value. It used to just be annual disclosure.
The sum of all these changes appear to give the Companies more discretion in determining asset prices rather than just marking them directly to market, which in many recent cases has had the effect of completely impairing many assets. In my mind the market for an asset is the one that exists today. Although well intentioned, I'm not sure these rule changes do anything more than put off the pain of an asset write down. If a market is distressed, that is the market one has to sell his or her assets into.
However, the rule changes are meant to help the bank or other institution where it is likely the cash does come in the door over the course of that asset's life, but because it cannot be sold today, the bank or other institution has to take an impairment today. In this instance, the rule changes do promote the idea of recording revenues and expenses in the period they occur.
Again, it all comes down to the integrity of the institutions abiding by the rules as to whether their assets are impaired or not. If one has an asset backed security containing subprime mortgages originated in Las Vegas, he or she faces both a disorderly selling market and a diminished likelihood that those mortgages payment continue to be collected. As long as some of those mortgages are performing, then it does seem reasonable that the asset should not be written down to five cents on the dollar, probably close to what someone would pay for it in today's market, and that just the credit losses should be recorded.
I was more fired up about this when I originally read about it last week. But my takeaway is that on a case by case basis you really need to understand the assets of a company you are investing in because with the new rules there is leeway to "stretch" the value of a Company's assets depending on one's definition of "orderly". Understanding if a Company has mispriced assets could give you an investment edge. And in many cases, the Companies that, under the old rules, had to write a number of assets down to zero, may be mispriced as some of those assets are surely worth more than zero.
As usual, companies with assets valued higher on balance sheet than what they are really worth, will face pressure in the stock market. I do not see the rule changes as stopping the inevitable, maybe just slowing it down a bit in some cases.
On another note, I promise not to mention the FASB for at least another two weeks. Man, that stuff is dry!
-2outof4
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Nice use of "kerfuffle."
ReplyDeleteFair value concepts seem to have taken a back seat just because people don’t like what assets are really worth. These seem like major changes based on the subjective definition of what an “orderly” transaction is and what is “distressed.” I can see both sides of the argument but am skeptical of giving more leeway for managers to interpret fair value. Just because I don’t like where an asset is marked I can now make the balance sheet a complete fiction that will overstate the firm’s financial position. In my short career of 8 years as a hedge fund analyst, I have never known a CEO or manager who was overly conservative to the point of marking illiquid of Level III assets well below their fair value.
This is interesting as the rules change may have implications for some of the Fed + Treasury programs. If I had “toxic” assets to sell to PPIP but I can now retain all the upside by holding them and not be forced to mark them to the downside, why would I sell those assets through PPIP at all? It would seemingly create an incentive to hold onto all the marginal loans and products that I would have otherwise had to mark down and only put the really, really awful assets in PPIP where I knew the mark on the asset was bogus over the long-run. I’d also think private buyers of those assets would understand that incentive structure. Just brainstorming, but maybe the well-intentioned (politicized?) rule changes could undermine the purpose of some of these other programs. I’m sure it makes my 401(k) happy today, but if financial institutions couldn’t price and manage these risks properly, why would they get a free pass to lie about the fair value of an instrument on their balance sheet?
Johnny -
ReplyDeleteThere’s a danger of lumping these three new standards together. In fact, this seems to be the flaw in your assessment. Each one must be evaluated separately.
I must admit that I have not digested the final standards. So portions of my analysis are based on recent drafts.
1) Interim Disclosures about Fair Value of Financial Instruments
How could anyone argue that increasing the frequency of fair value disclosures is a bad thing? Of course the short implementation date will present a real challenge for the companies it affects.
2) Impairment Model for Debt Securities
It’s important to note this will only affect the accounting for debt securities. In the draft standard, it was not clear if equity securities would be affected.
On the whole, I think these changes improve FAS 115 by making the standard more operational and improving the presentation and disclosure of other-than-temporary impairments.
The additional disclosures required are substantial. While I’m no analyst, it appears this standard will provide the investing community with enhanced information to assess the appropriateness of impairments both included and excluded from earnings.
3) Determining Whether a Market Is Not Active and a Transaction Is Not Distressed
This, of course, represents the most substantial change of the three standards. I think companies will really struggle to implement it by Q2.
As you have already pointed out, there is confusion about how to apply the terms like “active market” or “distressed transaction”. Interestingly, the common criticism of US GAAP is it favours a system of “rules based” standards rather than a “principles based” framework. I agree with this assessment. It is one of the reasons that US GAAP will eventually be replaced by IFRS.
In the abstract, most people favour the idea of “principles”. However, they run for the hills when faced with a specific example of how it will be applied. I think your comments reflect this way of thing. “We better not give management any opportunity to apply their judgement. Let’s stick with our rigid system of rules”
The aspect of this standard that confuses me is the methodology for valuing distressed transactions. The draft standard seemed to favour a methodology that is inconsistent with the “exit price” framework of FAS 157. So I am afraid we are replacing the preceding valuation methodology with a confusing framework that isn’t “fair value”
Hopefully the required enhanced disclosures will shed some light on management’s approach to valuing these assets.
Scesno