Thursday, April 02, 2009

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


14 comments:

see said...

Whats to stop banks and companies from changing their minds that their so called investments held to maturity will not be held to maturity after all when times better and hunky dory? Heck like that we don't need mark to market then

Gamelion said...

Whether it is mark to market or not r not much that matter now cos it just further delaying the inevitable of reporting very large sum of losses now to be carried forward to future !! Why dont they put all under the asset column as an account receivable where in the future they may stand a chance of collect it at full value ??????

ETONG said...

So we have 1 rule on the way up but another on the way down. When the upcycle kicks in again (it surely will), lets change it again so we can boost our profits.

Wah liao, how not not make money.

solomon said...

I am in favour of the changes of MTM. Not because of bowing down to the current economic situation. Simply, I don't appreciate fair value accounting. To me, nothing is fair until you could find a willing buyer and seller. There are so many uncertainties which depends on the economic situation and etc. Do you think a fair value is fair??

Like a poker game in casinos, change the croupier when you always lose.

What next, regulate the hedge funds??

yj said...

Dali,

If i were to sell u my house in Zimbabwe...would u want to know the value of it in US dollar or Zimbabwe currency ?

Salvatore_Dali said...

yj... i think usd... because i cannot count in zimb currency n it moves lower every day

yj said...

exactly my point...bcause u can value it accurately and it is more transparent to u as a buyer or investor...but what if i said that we shld use the exchg rate 5 yrs ago.....bcause to me..that's what i paid for .....would u agree to that ?..

Salvatore_Dali said...

yj,

if you bot a 1m house with 800k loan.. n u service it well... some calamity happened n nobody buys houses for a year, the bank valuer comes in n tell u there was 1 transaction in yr neighbourhood last week where it was forced sold for 100k, n now ask u to cough up the balance 800k... is that fair... u intend to stay there till yr retirement to sydney in 10 years time n have no problem servicing it... in a normal mkt there were 20 transactions in yr area a year... but now only 1 transaction owing to a lack of liquidity n fear...

n u have no way of coming up with 700k to pay off the loan... so how

yj said...

buying a property is an investment and when u talk abt investment..it's always abt risk..what more if in your example...borrowing to invest...entails even greater risk....of our in your case it is not fair but then the bank is also taking a biggest risk than u so...the bank has to protect its own interest .. your example is a very good one..bcause during 1997-98 in HK...it did happened..i remember some buyers houses were sold and they still owed the bank a very substantial amt...had to work few years to repay the bank....over leveraged and over speculated property mkt perhaps....they didn't coin the phrase "toxic" or "distressed" asset for nothing...

Jasonred79 said...

Dali, your argument is confused.

I agree that the banks should not have to post any collateral for those purchases, but a provision for loss is fair game... the thing is... those banks often DO sell those CDS to each other. In fact, those crazy banks buy and sell all sort of things. It gets quite out of hand sometimes.


Anyhow, I say I agree with your point, up to a certain extent. Basically, to use your man in a house analogy, I think it is fair that if you are keeping up with all your payments and can prove to the bank that you are solvent, you should not have to cough up the cash for your house.

On the other hand, IF your personal finances truly have cause for alarm, then it would be sort of fair.

In this case, let's not use a house that you LIVE in... let's use a house that you are RENTING. (since these toxic assets are meant to generate a stream of income, IIRC). Now, say previously, you were had a nice steady stream of tenants paying you 10k a month, now suddenly the rental drops to 2k a month, should your lender have cause for concern?

...

Anyhow... I agree with you insofar as you say "the bank has no intention of selling anyway, so why should it mark down a loss?"

That's good logic.

I think that the correct thing to do is present FAIR VALUE in accounting.

Mark-to-market is merely a shortcut.

As you said, these derivatives are nearly impossible to determine the value, so people just use it's "resale value". Simple.

However, I think a far more sensible method is using the classic "discounting a stream of income" technique.

...

Of course, the REAL BIG QUESTION is how much those toxic assets are actually going to fetch upon maturity?

...

Remember those Lehman Brothers High 5 Notes being sold at DBS?

...

Remember how many cents on the dollar those instruments gave?

ZERO. In fact, it was a negative number, but the banks just simplified that to zero.

Hmm.

Shana said...

@ YJ,

Sorry to interject in your chat with Dali, but your latest reply didn't answer Dali's Q) to you..."So How?"

Am curiously keen to know your response and stand...;)

With you agreeing that investment = a risk, is it naive of me to assume that with this agreement you'd cough up the 700k to the bank for your "distressed" investment?

Who would you call, for your bailout?

China said...

Creative accounting should be a core subject in accounting course. Who said accounting is boring, now? Creative accountants can run rings around IRB, SC, Bursa, Custom, Courts, lawyers and politicians.

KoSong Cafe said...

Dali, I think you have a really good point there, especially where it involves banks and CAR and the whole monetary system.

But where a company changes policy to suit itself, then it would be different...more a case of creative accounting. Someone somewhere mentioned Air Asia bites the bullet by taking into account its hedging losses while MAS has yet to show it in the accounts. If this is true (>Rm2 billion?), then MAS needs really huge profits to write off the losses, even if over a number of years.

Even a change in the format of accounts could highlight or hide significant figures - that is really creative!

rask3 said...

Hi,

Valuation of assets and liabilities is a malleable matter and before we bash bean counters for being staid, the repercussions of liberal accounting should be considered.


An asset can have values such as open market value, fire sale value, insurable value, bankable value, intrinsic value, long term realiseable value and so on. In the case of OTC financial products, we can have mark to market, mark to model and mark to mania. So which is fair and which is not? And to whom? It is a fact that many fortunes have been created with the mere stroke of a pen.


Long ago accountants grappled with the issue of which master they
should serve, since their constituents can have conflicting interests. If I am the manager of a firm and my bonus is linked to performance, a liberal stance on valuation of assets would suit me fine. Provided the external auditors don't throw up a tantrum or squeal.


That may not serve the interests of investors, trade creditors and loan creditors. So accountants have chosen the path of conservative reporting which serves most constituents well. It may not be fair to all but life is not always fair.


Coming to the impending change in accounting standards with regard to valuation of OTC financial products, I hope they don't let the creative genie out from its tightly closed bottle. That will create more problems than it will solve.


I propose that mark to market for such assets be continued. What if the market for such assets freeze up and market values don't reflect long term realiseable values? It gets tricky here and those who
got into a pickle sitting on such toxic assets are screaming for accounting relief.


I propose that for the purpose of reporting toxic assets be valued at market or written of if there is no market. It may not be fair but the alternative is even less fair considering the uncertainties of the future and the potential for abuse.


As for banks who have to comply with capital adequacy requirements, I propose that the toxic assets be valued at long term realiseable value. Or something close as I guess technicalities are involved here.
And only for this purpose and not for financial reporting.


End of lecture, lol.