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.

17 thoughts on “Accounting Rules Do Not Affect Cash Flows

  1. Well said.

    It is always interesting to me when commentators or legislators act as if the accounting drives economic reality. “If we book it this way, then it must be so.” I always thought the whole point of accounting was to provide insight on economic reality. As we learned with stock option expensing in the 1990’s (and fair-value attitudes now), many in positions of authority have other agendas.

    As you say, other agendas or not, it doesn’t change the cash flow. Or the eventual outcome.

  2. Hi David,

    I agree with your conclusion. But to be fair to the criticism of fair value, banks have internal and external (Basel) capital adequacy requirements. And, for banks, the specific sensitivity to asset value is acute due their (by definition) high leverage. If asset valuation is abrupt and incorrect on the downside, it triggers otherwise unnecessary balance sheet responses (and further, some research shows this transmits). I know you know this. I just think it’s a hairy trade-off for banks. If the premise is true (investors care only about cash flows) then, it should not matter how exactly it is reported. This is why I agree with CFA institute that FV isn’t the problem so much as accounting-based capital adequacy requirements. David Harper

  3. Can’t mark-to-market also cause problems? What if a company marks assets up to market prices that overvalue those assets (let’s pretend tech stocks in 1998)? Then lends based on that higher capital, then get into trouble when those assets decline in value, and their leverage works against it?

  4. David, I obviously have substantial respect for your opinions (on RM) and blog, but what’s up with the smarmy comment about people (actually, fellow congregants) who work for the government? Maybe you’re referring to Bush acolytes who are just passing through the revolving door. But the vast majority of government workers I’ve encountered are hard working and honorable, and have, in fact, taken a pay cut for the privilege of serving the public.

  5. But this is otherwise best explanation, I’ve read, of the mark-to-market debate. Absolutely must reading.

  6. Thousands of institutions hold thousands of corporate bonds that trade infrequently. Just because this is not your business model (nor mine) does not mean that it is wrong. Investors purchase bonds or other instruments with the plan to hold to maturity.

    You make a fatal error — confusing “fair value” with “mark to market.” Astute observers are coming to the conclusion that distressed pricing of illiquid securities is not “fair value.” It is something between the distressed price, and the face value price.

    What is needed is a method of price discovery so that the actual fair value can be determined. In the meantime, many regular banks with normal investments are being unduly punished by FAS 157. This is about to be fixed.

    And it should be…

  7. q1 — If I may, nothing smarmy here. Wherever I have lived, in any church I have belonged to, there is usually a dominant employment influence. Since my congregation is near DC, it is no surprise that it is the US government. I respect my brothers and sisters in my church, but I am in the minority in not working for the government. What is interesting with my lawyer friend is what passes for information in attacking economic problems.

    My congregation is fairly non-political, as evangelical congregations go, because neither the Republicans nor Democrats fit what we think.

    I have also learned not to probe my friends who have security clearances… in general, I don’t want to know.

    Does that help? The comment was innocently meant.

  8. Jeff, I haven’t made that error. I know the difference, and have written about it previously. If you have thin markets, you are not required to mark to “last trade.” You can use your model.

    But suspending fair value rules is foolish. SFAS 157 and 133 require best effort to come up with “fair values” for volatile instruments. They are as volatile as equity, so they ought to be valued as such — at the best estimate of the market clearing price between uncoerced buyers and sellers.

  9. David –

    While your point is accurate about the CFA Institute’s position reagarding accounting for capital adequacy– they are just as strong in their position supporting market to market and fair value.

    The reason? Investors demand transparency, and SFAS 157 and 133 helps provide just that. Of course speculators can overlook such things… to their own demise.

    Very well written article, by the way.

  10. Hi David,
    I agree with Jeff. The accounting “framework” breaks down here b/c of real world realities. Mk to Mkt & 157 were appropriate for entities like GS, Lehman, Bear that were broker/dealers. Not for banks, where using impairment would make more sense. Even if you are an entity with $$ to invest, the “deadly embrace” of MtoM transactions would cause you to hesitate to do it; this reinforces illiquidity. Cash Flow becomes irrelevant when your reporting must be approved through SarBox, auditors, and then interpreted by rating agencies. The excesses aren’t the fault of the accounting, but the unintended by-product is like frontier justice – any guilty plea is followed by a hanging, even for parking your horse in the wrong place!

  11. Insurers are hot news today with all of the stuff that Senator Reid never said. Hartford now at $25.

  12. But M2M vs fair value is not quite the issue. (I still agree with David, I am just pointing out the devil’s advocate). If an otherwise relatively liquid asset becomes suddenly illiquid, then a FAS 157 fair value will be market to model; the “fair value” invariably will need to include a illiquidity discount. The systemic problem is that, a bank has capital adequacy (leverage) requirements and, all other things being equal, the bank now must react by shrinking its balance sheet, which transmits. So, the problem with “fair value” is that it should incorporate a discount for temporary illiquidity. This causes pain. FV is the worst approach, except for all the others.

  13. David,

    I now see that I misinterpreted your comment. Thank you for taking time to respond.

  14. Wow. This is the most reasoned site I have stumbled across in terms of this debate. As a UK-based auditor of hedge funds, I am constantly amazed at the US usage of the term “fair value” vs the European paradigm. To us, if an accounting requirement provides the market with more data, it is a good thing, no matter what the pain: investors should be able to distinguish between accounting consequences and cashflows and investing entities (be they banks or funds) are only letting themselves down if they don’t give investors the info required to make their own decisions – sentiment CAN be managed as non-GAAP info can be published alongside GAAP info.

    It seems that on your side of the pond, there are big hitters saying that FV is the cause of the current difficulties and this monopolises our view of how your entire nation sees things.This blog is therefore refreshing as it robustly sets out why this is not the case.

    Aside from this, the way FAS157 is set out, really doesn’t help: people take FV to mean mark to model, as a result of the way the standard is drafted. This allows jingoism and gives currency to the FV paradigm’s detractors.

    FV is mark to market, as far as I am concerned, and only becomes mark to model where markets do not exist. Thin markets are still functioning ones.

    There IS a real point about M2Mkt vs M2Model, but FAS157 and IFRS7 (in my geography) both deal with this, and – when properly applied – are an aid to efficient capital markets, not a hindrance, and won’t cause a run; provided communication is balanced by requiring inclusion of non-GAAP measures and proper disclosure of strategy: a fund that invests (broadly equivalent to “buy to hold”) is not the same as a fund (or a bank) that trades, and context is everything.The corporate communications industry is clearly missing a trick here – balanced communication is what is required, not moaning about accounting disclosures.

    Let the bad guys fail, but it’s a shame if those who ARE transparent on FV are punished because they are na?ve around communications or because the other guys choose not to apply FV in the first place

  15. MC, Assetman ? thanks. Personally, I?m a little surprised at the debate on this in the US, and the willingness of the regulators to ?roll over and play dead.? The academic literature on accounting rules are clear ? investors look through to the cash flows. Suspending fair value will not change the cash flows, and may not buy banks more time. That said, fair value is often misapplied to mean ?last trade,? which isn?t even the way we value things as simple as mutual funds in the US.

    The CFA Institute took the right path on fair value; let?s see if they can maintain it against political pressure. Thanks for commenting.

    Henry Buttal, all I can say is that SFAS 157 may have played a minor role, but owning illiquid assets, financed by illiquid liabilities, with insufficient slack assets (surplus in excess of risk requirements) is a recipe for disaster.

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