Accounting Rules Do Not Affect Cash Flows

At my congregation, I have a friend who is a lawyer at the Justice Department.  (Such is life for a congregation located near DC.  I am one of the few that does not derive his income from the government.)  He has asked me a couple of times about SFAS 157, and the effect it is having on the current crisis.  My recent comment to him was:

Accounting is a way of portioning economic results by time periods.  It doesn’t affect the cash flows, but tries to allocate economic profits proportional to release from risk.  If we were back in an era where the financial instruments were simple, then the old rules would work.  But once you introduce derivatives, and securities that are called bonds, but are more akin to equity interests, you need to mark them to market.

Equity instruments have always been marked to market, because of their volatility.  Similarly volatile debt instruments should be marked-to market.  Even the the old-style “hold-to-maturity” bonds would get marked down if there was a “permanent impairment of capital.”  Even today, the same rules apply, the companies could specify certain volatile bonds as hold-to-matutrity or available-for-sale.  But when the auditors look at the bonds, and ask what the market price is, the challenge is to explain why there is no permanent impairment of capital.

Those that are complaining about SFAS 157 and SFAS 133 are barking up the wrong tree.  They wouldn’t be complaining if the companies in question had not bought inherently volatile assets.  These accounting rules reveal the results of their actions.  The regulators could ignore the rules of FASB, and allow the financial institutions to balue them otherwise. The regulators have a different attiuude; they don’t care about profitability, but they do care about solvency, and avoiding “runs on the bank.”
A very well-established rule in academic finance is that changes in accounting rules do not have much impact on stock prices on average, because they don’t affect cash flows, and free cash flows are the major basis for evaluating stock prices.  If a financial company holds an impaired security, eventually that will factor into the cash flows regardless of what the accounting rules are.
There are a number of articles today on this issue:

FASB has offered a little more room to interpret the mark-to-market rules, but only a little.  Congress could mandate more latitude, though I think it would be a mistake.

Mark-to-market accounting should pay a role in valuating volatile financial instruments.  Now that financial institutions have bought financial instruments more volatile than tha buy-and-hold attitude of the old days would have done, ther rules must adjust to present a fair value.
I don’t see any way that lets the markets gain from the suspension of the rules.  The rating agencies will still do calculations of risk based liquidity on financial firms to set ratings.  Here’s a way to test though.  Go back to my old proposal that we have two income statements and two balance sheets.  Let the market see both a fair value and an amortized cost appproach.  If fair value is distorting, then investors will welcome and use the amortized cost figures in their calculations.  More information is better than less, and it is trivial to add back an amortized cost balance sheet and income statement.
For complex balance sheets in volatile times, I know which one that investors will prefer — fair value.  Let the advocates of eliminating fair value explain why reducing information to investors is such a great benefit.  In the end the cash flows will be the same, and maybe it will take a little longer, but the results of bad investment decisions will be revealed, and the same firms will fail — perhaps in yet more ugly ways, as their shenanigans will go on longer, with less to recover for the bondholders, and wiping out the equity entirely.
In the absence of fair value, suscpicion will take the place of information, and companies will still get marked down as failure takes place in fixed income assets classes.  The same things will happen, just in a messier way.  You can’t fight the cash flows arising from bad investment decisions, and too much leverage.