Accounting – Fraudsters Weapon of Choice

With recent changes in accounting rules one has to wonder, whether balance sheets and income statements are still a reliable source of information as regards the state of a financial institution. Of course, in this we assume that balance sheets and income statements have been a reliable source of information in the past. This assumption is open to debate, but let’s make it anyway.

On October 13, 2008 the IASB amended IAS 39: Financial Instruments: Recognition and Measurements and IFRS 7 Financial Instruments: Disclosures, which are both described here. The rule change allows “entities”, to reclassify financial assets from the available-for-sale category to the loans-and-receivable category. Or in other words, change from mark-to-market valuation to mark-to-maturity valuation. The FASB has made a similiar rule change.

At first sight, this doesn’t look particularly bad, after all, executives are given great latitude in the valuation of their assets and the assumptions they make. So, where is the problem?

The financial assets we are talking about here are the so called toxic assets and are debt-securities, whose mark-to-market value was way beneath what the holders thought it was worth. Those mark-to-market values were derived in a process between the banks in which each told what it was willing to pay for the assets of other banks (lots of potential for ‘cooking’ here already, since few players in a tightly knit league determine each-others values, how objective can that be…).
The values arrived at with this process were based on the expected cash-flow the asset would generate over its lifetime and the risk, that the cash-flow would be less than was expected. So banks decided that buying more of those assets was too risky and the price for those assets dropped to low to be sold with a profit. No one wanted to sell with a loss.

Wouldn’t it be nice then, the bankers thought, if we could just value these toxic assets with a value that is closer to what WE would like it to be (since our bonuses depend on that). They were allowed to do that with the rule changes and mark them up. Hence the profit the banks showed in the first quarter, which was – at least to a high degree – based on those reclassification.

The problem is, that the banks now can assume what they want about the riskiness of their assets and basically value them at any price they see fit, regardless of what others would be willing to pay for those assets.
It is then obvious, that now you can no longer be sure about the validity of the figures in the balance sheet, so you are investing – or depositing – based on faith and not on facts.

This is bad news. In my view the both the FASB and IASB have abandoned the true-and-fair-view principle of accounting and replaced it with the it’s-worth-whatever-I-say-it’s-worth principle and it opens the door to fraudulent behavior even wider.
Apparently, I am not the only one to think so.

Below a comment I made to the SEC

And then there is the PPIP, which will be influenced by these valuations as well. The FT writes in an article today (emphasis by me):

Most notably, if large American banks had previously marked their assets at a realistic market-based price, they would not be so scared of engaging in auctions with PPIP now. Better still, they might have spotted earlier the degree to which their assets were deteriorating – and taken action to address it.

But precisely because the supposedly “free market” western financial system has become stuffed with complex assets that were rarely traded – even during the credit boom – banks have been able to use fantasy prices for their assets for years. Hence their continued horror at the idea of open trading.

That is the real scandal that bedevils the PPIP idea. That in turn points to a wider lesson for the future: namely that to avoid a similar credit disaster, it is crucial that financiers are forced to place as much financial activity as possible on transparent trading arenas. Better still, they need to do that well before a bubble bursts – or there is any need to start fighting over whether a PPIP can truly fly.

I think the FT got it quite right.

UPDATE: Just found this article on Reuters. Looks like the FASB is getting second thoughts about those changes.