The Economics of SFAS 157

I’m not crazy about flexible accounting standards because they destroy comparability across companies, with perhaps a gain in accuracy within companies. We’ve had a lot of noise in the blogosphere recently regarding the SEC allowing companies to ignore prices if they are the result of forced sales or tax-loss selling. You might expect me to say that the SEC is nuts again. You would be wrong.

I am aware of reasons there are economic for one party to sell, that do not appeal to the bulk of investors, and I have seen forced sales for tax and other reasons. Even with those sales, the market is thin. Almost every transaction is special; trades are by appointment only, unless someone offers a humongous bargain for immediate liquidity. I have seen this in the market myself, and seen management teams struggle with how to price an illiquid bond when tax loss sellers bomb the market at the end of a year

So, when I read facile pieces suggesting that FAS 157 has been gutted, (and here) I just groan. With level 3 assets, the markets must be very thin, not nonexistent. Prices in a thin market rarely represent the net present value of the future cash flows to the average market participant.

Also, one should realize that SFAS 157 merely cleans up the rules for how assets are to be valued under SFAS 133. Calculating “fair value” is often hard, though unscrupulous managements will take advantage of that flexibility. At least we have rules to determine when we use market prices, figures that derive directly from other market prices, and figures where a discounted cash flow analysis, or something like it must be employed.

Was the move of the SEC a big help? A help, yes, but a wee one. Companies could already under SFAS 157 make the argument that the SEC blessed. The SEC simply makes that argument easier.

All that said, I don’t think that SFAS 157 has that much economic impact, compared to the way firms finance themselves. A loss of liquidity does far more damage than volatility in earnings results, unless there are debt covenant violations.

In the end, I am saying that there is an issue here, but it is not a big one. Better that companies in trouble would lower their leverage, and finance long-term, which costs more in the short run but preserves the company to fight another day.