We need to kill mark to market accounting before it eats us alive. These accounting rules are like The Blob, an alien life form that consumes everything in its path as it grows and grows. Both the Blob and mark to market accounting crawl, creep and eat everything dead or alive in their path. We need to save ourselves by putting mark to market accounting into deep freeze while there is something left to save.
Before I proceed (and get flamed by angry commenters), I want to set the record straight. I believe financial statements should present a conservative, consistent and realistic report of results of operations, financial condition, cash flow and contingent liabilities and assets. Bad assets and poor management decisions should not be hidden behind accounting manipulations. Loan loss and other reserves should be conservatively determined and uncollectable assets should be promptly written off. Accounting rules shouldn’t drive business decisions, they should reflect them.
However, mark to market rules distort financial results and business decisions under the false cloak of conservatism. The rules make little sense, produce inconsistent results, lack a basis in reality and provide lots of room for abuse. They should be suspended immediately before more damage is done. And, the damage is a distortion of common sense business decisions and financial reporting. Mark to market rules are one of the worst manifestations of the “trader” mentality that spread from Wall Street to the rest of the country. Wall Street traders with severe attention deficit must have drafted these accounting rules because they push valuations and reporting of business decisions into the “moment” (which is worse than the short term) and use the equivalent of “financial sound bites” to determine value. The false premise that the price for which an asset can be sold for at this minute is the true value of the asset underpins mark to market accounting. One of the basic claims of the Paulson Plan, that only the government has the patient capital necessary to own financial assets and wait until they pay off at maturity, is the ultimate indictment of the crazy results of these accounting rules.
And, like The Blob the rules keep on expanding and expanding in their application. On January 1, 2009, all merger and acquisition transactions will be subject to mark to market accounting.
So, let’s kill The Blob before it kills us.
Set forth below is “why” we need to get rid of these rules before they eat us alive.
1. Mark to market accounting assumes that what people are willing to pay for an asset is always the same as the asset’s value. This assumption is wrong.
When assets are tradable, transparent and liquid, what people are willing to pay is the “real” value. But, when assets aren’t traded and are illiquid and opaque (like a private bonds or loans), market prices are a worthless measure of value because there is no market to establish value. Not all assets that have no trading market are bad assets; most of them are just private loans to individuals and businesses. Before mark to market accounting, loan loss and valuation reserves were established for uncollectable obligations and assets.
A few years ago I had an experience at an aircraft spare parts trading company that illustrates the limitations of market value accounting. At this company there were many spare parts that had an active bid/ask market and reasonable market values were quickly established without controversy.
However, in one corner of the hanger there were spare nose cones for Boeing 737’s. Each nose cone had a historical cost of $10,000. The current market value of each nose cone was less than $1,000 and was equal to its aluminum meltdown value (scrap metals dealers were the only buyers). However, if anywhere in the world a Boeing 737 broke its nose cone; my client would sell one of his cones out of inventory, usually for greater than $50,000.
Mark to market accounting would have valued the nose cones at around $1,000 per cone. Before mark to market accounting, $10,000 would have been their carrying value.
The above example illustrates three flaws with mark to market accounting.
- Mark to market accounting uses quick sale valuations which are non-going concern liquidation values for assets and are almost always lower than going concern valuations. However, a core GAAP assumption is that companies are going concerns and violation of that assumption destroys the value of financial statements.
- Valuing nose cones at melt value shifts income from the period of the mark down to the period of the sale (as well as inflates expenses during the period of the markdown). This distorts the income recognition principal that revenues and expenses should be recognized in the period incurred.
- Mark to market accounting distorts management decisions and market prices. The application of mark to market accounting stops management teams from investing in new assets that are subject to subsequent quick sale liquidation analysis. One of the problems in the current credit crisis is “banker refusal” to make loans to companies and consumers because of the risk of an immediate mark down upon origination. In the above nose cone example, if mark to market accounting is used, no spare parts trading company will replenish supply once their nose cones are sold. The application of mark to market accounting to nose cones will drive the market price of cones to $1,000 despite the ultimate realizable value of $50,000. This type of price distortion is currently driving the market for many financial assets.
2. Inaccurate proxies and bottom feeders have become the “market” for accounting purposes.
By definition, assets without a liquid and trading market don’t have a market in which to determine market value. Accountants have been using “proxies” to estimate the market for illiquid assets. But the use of proxies is flawed.
- Often, accountants are using proxies that are themselves illiquid and thinly traded. Applying the principal of “garbage in, garbage out”, it is easy to see why estimating an asset’s market value based upon a proxy that doesn’t have a clear market value isn’t good.
- When accountants can’t find a market or a proxy, they are using distressed quick sale prices. Most illiquid assets are illiquid because they have individual qualities and can’t be valued without a lot of buyer work to understand the risks and benefits of the investment. Due diligence and analysis are inconsistent with quick sale analysis. Fundamental value investors don’t purchase assets in quick sales. However, bottom feeders “live” to purchase illiquid assets with limited due diligence. Bottom feeders hedge risk through low price. Since the mark to market rules favor quick sale prices and bids, valuations migrate to bottom feeder values regardless of the quality of the assets. Again, management decisions are distorted as accounting valuations migrate to bottom feeder prices.
3. Sometimes the whole is worth more than the sum of its parts. Mark to market accounting values the sum of the parts.
Mark to market rules value each component part of a business rather than the business as a whole. When I was a kid, I decided to take apart the family lawnmower. Before I messed with the mower it was worth about $100. However, once it was spread apart across the floor of my parents’ garage, the mower had little value. Each part was just valueless junk. If I could have put it back together, the mower would have again been worth $100.
Mark to market accounting values each component part of a business or a portfolio on a stand alone liquidation basis rather than as a whole.
GAAP accounting continues to expand valuing each component part at its quick sale value. In January, 2009, changes to merger and acquisition accounting will be phased in and will continue this trend to “spare parts” valuation.
4. Mark to market accounting isn’t uniformly applied across companies and industries. “Form over substance” is about to rule the day.
Further confusing investors, mark to market accounting has inconsistent application across industries and companies. As an example, insurers and banks account for similar transactions differently, as do banks and brokers.
Different accounting for the same transactions and investments confuse investors and is inconsistent with the objectives of GAAP.
And, mark to market accounting favors private companies over public companies. Private companies don’t have to worry about this ridiculous accounting rule and will over time be more likely to attract capital. Mark to market accounting is contributing to the destruction of the U.S. stock market and capital markets and is another unintended consequence of these rules.
Accounting should be the same for the same transaction regardless of the form or ownership structure of the company.
5. Mark to market accounting allows management teams to manufacture earnings.
Mark to market accounting is a “double edged sword” – it can and has been used to manufacture earnings. It is no coincidence that Lehman Brothers failed after manufacturing $2.4 billion in pre-tax profits by “marking to market” its liabilities. Mark to market accounting assumes that a borrower, like Lehman, can go into the market and purchase its debt at the “market price” rather than repaying it in ordinary course. Sure…enough said about that.
Mark to market accounting needs to go. We need consistent, conservative and realistic financial statements and reject the bottom feeder trading valuations of mark to market accounting.
We need to kill The Blob before it eats us.