Wednesday, April 22, 2009

CFA States That Weakened Mark-to-Market Rules Undermine Investor Confidence

The comments below are from Kurt N. Schacht, managing director, and Patrick Finnegan, director of financial reporting policy, of the CFA Institute Centre for Financial Market Integrity, a global association for investment professionals. They commented on FASB's ruling on mark-to-market accounting changes.

On April 2, the Financial Accounting Standards Board did what many investors feared and what the banking industry hoped for - it eased the financial reporting standards concerning a technical area of accounting called "impairments."

Simply put, an impairment is when the market value of an asset or liability is less than the value reported on a company's balance sheet. The consensus is that political and special interest pressures forced FASB's hand to make this change, even though it is supposed to be an independent, objective standards setter.

Federal regulators, such as the Securities and Exchange Commission, and the Obama administration now need to look harder at banking regulations to strengthen financial institutions and restore the confidence of investors.

Unfortunately, FASB's decision has only amplified the natural tension between the interest of investors in transparent, unbiased financial reporting, and the interest of business executives in casting a company's finances in the most positive light. Positive is fine, but inaccurate is not. The curtailing of the FASB standard diminishes this accuracy and, as a result, investors and lenders will find it more difficult to differentiate between high-risk and low-risk firms.

Complaints about fair value reporting, which determines the price that the investment marketplace should pay for an asset, have arisen largely in the context of their effect on the measures of a bank's ability to cover its loans and meet its financial obligations. One way to make the bank's capital look better is by changing the accounting rules. This is the exact dilemma the FASB faced last month and folded on.

A better alternative, and one the CFA Institute Centre for Financial Market Integrity has urged Congress and banking regulators to consider, is to address capital adequacy concerns through the banking regulations, not financial reporting standards. Fair value accounting, also known as the mark-to-market rule, did not cause our banking crisis any more than gutting the rule will solve it.

It is a mistake for FASB to encourage poor accounting practices in hopes that doing so will erase years of poor lending practices, inappropriate risk management, executive compensation schemes that were not aligned with company performance and thus were not in investors' best interests, and poor corporate governance. Yet, on April 2, FASB rushed to modify these important accounting rules.

So, where do investors go from here? Here is what to watch for:

-- Companies' early adoption of the new rules: This probably signals a more aggressive approach to adjusting their financial reports. Investors should watch to see which companies suddenly look much healthier now compared to previous quarters.

-- How bank assets are reported to the SEC and investors: Read the fine print of notes in annual and quarterly reports to understand the changes in assumptions company management makes and the related financial impact. If these disclosures are not clear, they will likely serve to further shake investor confidence.

Federal regulators, Congress and the Obama administration now have a larger duty to protect the interests of investors. They should:

-- Resist all opportunities to pressure so-called independent standard setters into doing their dirty work.

-- Determine the true level of economic capital in our financial system, stress test it and then decide which financial institutions should receive more capital support.

-- Insist that the SEC be on the alert for those who may take the new FASB rules too far.

Real people live with fair value accounting every day. Looking at one's 401(k) statement these days may hurt, but ignoring it doesn't put more money in your account. When you go to the bank for a loan and use your stock portfolio as collateral, the bank is not interested in what you think the assets may be worth once they recover. They are interested in only what your assets are worth today. Why should the rules of the road be any different for financial institutions and other public companies?

Fair value accounting doesn't create problems, it just identifies them.