Mark-To-Market, The Wonders Of Accounting

I was an accounting and finance major, heck I even did honours in the driest subject ever created, accounting in my 4th year. Accounting is a made up subject. You just have somebody a hundred years ago devising a way of recording assets and liabilities by dividing a page into two columns. What started as a convenient way recording assets and liabilities morphed into this thing called accounting.

Accounting is very much like fung shui (there I go offending 90% of my readers again), its made up as you go along.

Now the market seems to be favouring the fact that there will be some accounting rule change tonight in the US which may actually add legs to the current rally. It centers on approving changes to "mark-to-market" accounting. I spoke to a very very rich man 3 months back and told him that one of the likely market catalysts will be changes to mark-to-market accounting. He was taken aback, and just like the MAJORITY of investors and readers, including the CFA association - almost everyone is condemning or has condemned changes to mark-to market accounting as stupid, silly cosmetic and ineffective.

I am in the minority I guess. I have been around accounting figures long enough to know that accounting numbers DO NOT fully represent what the truth is. Accounting is just an approximation to the truth. If accounting rules are the best approximations to the truth, then by all means we need to maintain the boundaries and stick to the accounting rules - so that things can be appraised fairly and consistently.

What I don't get is how so many hold onto accounting rules even stronger than the tenets in the bible. Change some accounting rule, its worse than blasphemy!!! Gee, its just accounting.

I fully appreciate why most would not want mark to market to be tweaked as that may be largely cosmetic and is seen as a move pressured by the banks and government on the Financial Accounting Standards Board. Why change now,... if the fundamental argument is sound to change mark to market, why not change it years ago??? Aha!!!

First, let's look at the proposed changes that are likely to be passed. Banks may not need to undertake impairment charges if the banks say that 1) they do not intend to sell the affected asset, and that 2) they probably won't be forced to sell before it recovers. The banks will only record the losses upon maturity of the investment (assuming they are paper assets / bonds / contracts / derivatives). Thats all fine and dandy, but the key phrase is the second part which says that the banks WON'T BE FORCED TO SELL before it recovers.

For a bank not to be forced to sell, the bank will have to show safe asset-liabilities ratios and decent tangible common equity. Values of an asset may be destroyed temporarily and unfairly by:
a) a lack of liquidity
b) a temporary confidence crisis

Is this all cosmetic? No. Should the above rule be passed by FASB? Yes. My reasoning: If a bank were to hold a group of assets, and they all lost value, why the need to write off the impairment charges all in ONE YEAR??? These are assets which, if they do not sell, will be part and parcel of the company for 5, 10 or 20 years. I see them as being equated to buying an office building or installing a manufacturing line - good or bad, you don't ask the company to write down the entire cost of the building or manufacturing in the one year!!?? You AMORTISE it over the life of the asset.

In the same vein of thinking, while I am in agreement that there should be changes to the mark to market rule, I do think there is a better way. If the bank holds a $1bn contract but its low liquidity over the past few months makes it trade at just 40 cents to the dollar, and the contract expires in 5 years - the current rule would force the bank to write down $600m in losses. This is severe as it whacks at the capital adequacy ratios immediately.

A fairer way is to look at the impairment charges over the life of the contract and amortise the known losses over that period. Hence the bank will only need to write down 600/5 = $120m of impairment charges this year, and remember to footnote how/why you did it in the reports. If the market improves the next year and the asset now trades at 60 cents to the dollar, then you do the necessary write back over the remaining life. Tell me if this is not a fairer way of reflecting reality.

A complete and sudden whack of impairment losses is not just a temporary accounting entry. Some may argue that they can writeback the gains when markets improve in the 3rd or 4th year - thats fine if the writedowns do not have a significant bearing on capital adequacy ratios. If you CAR drops from 11% to 1% because of a huge writedowns on assets (which you do not intend to sell until maturity), that bank will have to claw a huge amount of capital from somewhere else, raising new funds via placements or rights issue to satisfy the regulators. Two years on, the market improves and then they have excess capital now thanks to the writebacks. But raising $1bn in difficult times, and giving back $1bn in good times ARE TWO ENTIRELY DIFFERENT THINGS to the company and investors, they do not equalise each other out.

The yo-yo volatility effect on shareholders interest, especially dilution of minority interest, and more importantly, the way management is forced to run the bank with such extreme volatility NEEDS a complete rethink.

Hence its not a travesty to make changes to mark to market accounting. The thing is mark to market and the whole shebang known as fair value accounting is still a "work in progress". The current extreme crisis has basically showed its flaws and inadequacies. Fair value accounting today is inadequate and sub-standard, stop defending it as if its cast in stone and brought down by Moses.

Approval of changes by FASB will move the markets higher and add legs to the rally. Its really not just cosmetic or artificial as it will have a realistic effect on affected banks - they can delay raising capital in such difficult circumstances. I think I will send this as a premise for my Phd in accounting ...lol.

p/s photo: Deborah Priya Henry