Judgment Too Important to be Left to the Accountants

This post is from Peter J. Wallison of American Enterprise Institute.

The Financial Times recently published the following op-ed piece of mine, entitled Judgment Too Important to be Left to the Accountants.

Two serious asset bubbles–the dotcom explosion of the late 1990s and the recent dizzying ascension in housing prices–have developed in the US economy within the past decade.

Given their damaging consequences, it is time to look for causes. One area that merits attention is fair value accounting, which was adopted as policy by the accounting profession in the 1990s.

This accounting convention requires financial intermediaries to carry their assets at market values, even if those assets are not being held for trading purposes.

When the dotcoms were in vogue, the assets of securities firms and other equity intermediaries were inflated, just as, more recently, rising housing values made banks and other mortgage lenders look flush. Inflated balance sheets and income statements supported more borrowing and more leverage; suddenly, the markets were awash in liquidity and risk premiums fell to unprecedented levels. It could be argued, then, that fair value accounting was the hothouse in which these bubbles bloomed; when prices are rising this system seems both to stimulate and ride the wave of irrational exuberance.

But matters look much less agreeable when the same asset values are falling. Then, the process works in reverse, and the spiral points downwards.

As assets fall in value, leverage rises, creditors and counterparties demand more collateral coverage, and companies must sell assets that they can no longer finance. Forced asset sales drive down prices, causing further write downs of assets under fair value principles–even for those who are not selling. And so it goes on. The downward spiral is continuing as this is written, and where it stops nobody knows.

Fair value accounting also has a one-size-fits-all quality that mimics the inflexibility of over-regulation. Valuing assets with reference to the market seems reasonable for firms that earn their profits from, say, buying and selling securities. In that case, what the market will pay for the firm’s assets and liabilities at any given time may be a good way to assess its overall value. But what about intermediaries such as commercial banks, which are generally in the business of profiting from cash flows? Does it make any difference to an investor in a bank–an investor who is looking to the bank’s success in corralling cash flows–that the market value of the assets that produce these flows may vary?

Many banks point out that the cash flows on portfolios they have substantially written down are doing just fine. A wooden application of fair value accounting to banks–while it may simplify the work of accountants–seems to do a disservice to bank investors, and even more so bank depositors.

If, as banks claim, fair value accounting is causing commercial banks to appear much weaker than they are in fact, it is creating a financial crisis where a mere slowdown might have been warranted.

Fair value accounting is clearly the reigning orthodoxy among accountants, but is that the right test? Accounting is simply a measurement system. What we want to know determines what and how we measure. Which is more important, the balance sheet or the income statement? Do we want to measure financial strength or earnings per share or cash flows? Is the purpose to inform equity investors or creditors and counterparties? Does one measurement system meet all of these objectives?

Given its impact on institutions and whole economies, common sense suggests that we consider whether one means of measurement is the only one we should be looking at. The world view of accountants at a particular time should not determine the answers to these questions.

It is important to recall the famous remark of Clemenceau that war is too important to be left to the generals.

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7 Comments

  1. Robert Dresser
    Posted Tuesday, May 6, 2008 at 6:06 pm | Permalink

    I couldn’t agree more. After Enron I did small time presentations to groups about what happened there. I told the story told me by my 89 year old father-in-law about how accounting used to be done in the 1940’s. When old-timer CPAs see this stuff they seem to be disgusted with how the accountants have evolved. The tragedy is that the “experts” in the field think they are right. I recommend a return to cost based accounting. That is, if the bond will pay $100 thirty years from now, its value on the books should be $100. If the plant costs $100 Million to build that is its value from which it should be depreciated. I particularly like those who recommend that the SEC make companies report their tax return income statements and balance sheets. Now that would be transparency at last.

  2. Michael F. Martin
    Posted Tuesday, May 6, 2008 at 6:24 pm | Permalink

    “Accounting is simply a measurement system.”

    Finally some common sense! Everybody is always complaining about accounting standards. It’s not the frame of reference that you use to measure a system that determines whether it’s a mess or not. It’s the system itself.

    There is a group of people who specialize in quantitatively matching experiments to theory very accurately: physicists. Why not bring a few in to analyze the incentives in the subprime mortgage industry? Given them a handful of simplifying assumptions (such as the fundamental rational hypothesis of economics) and they could have predicted that the way the subprime mortgage market was setup was going to lead to instability:

    http://brokensymmetry.typepad.com/broken_symmetry/2008/05/modeling-the-su.html

    “What we want to know determines what and how we measure.”

    A commonplace among physicists since Heisenberg pointed out that you can’t get an accurate measurement of both position and momentum below a certain length-scale. There must be similar Fourier pairs in accounting.

    It’s no accident that a lot of important accounting conventions were developed by scientists and engineers. Maybe we need to keep people with this kind of training more closely involved as we invent new securities.

  3. Peter D. Kinder
    Posted Tuesday, May 6, 2008 at 6:52 pm | Permalink

    A response to Mr. Wallison’s article:

    FT.com 5/5/08: Letters – Accountants do not make investment decisions

    Accountants do not make investment decisions
    Published: May 5 2008 03:00 | Last updated: May 5 2008 03:00

    From Prof Peter Walton.

    Sir, Peter J. Wallison makes an interesting point about the role of fair value measurement in the credit crisis (“Judgment too important to be left to accountants”, May 1). It is certainly important to consider in the wake of the crisis whether the use of fair value to measure financial instruments for balance-sheet purposes causes exaggerations of market movements. However, I would suggest the situation is much more complex than is implied.

    In the first instance, financial reports provide information to investors. The investors are supposed to exercise judgment in using that information to make investment decisions. Mr Wallison’s article can be read as a request to “shoot the messenger”. Accountants and auditors do not make investment decisions.

    Second, fair value started to be used for financial instruments precisely because historical cost was found to be inadequate. Twenty years ago entities were entering into derivatives and futures contracts with little or no historical cost but potentially lethal economic consequences. They escaped recognition in financial statements until the losses were realised: measuring them at market value was thought to be the best solution to protecting investors. Mr Wallison does not offer any alternative measurement approach that might be better. Winston Churchill’s remarks on democracy might be applied to fair value.

    The desire of banks and others to move assets and liabilities off their balance sheets is also a significant part of the problem. Investors may or may not make good use of the fair value information provided, but at least they have it. To an extent, standard-setters and market regulators are in a perpetual battle to force some entities to provide enough information to investors. The standards are always going to lag behind the preparers’ ingenuity.

    Another aspect Mr Wallison does not mention is that reporting banks are always free to provide additional information outside the financial statements to help investors draw the appropriate conclusions if they feel asset values are understated. But if asset values are understated, why are these same banks not snapping up these bargains?

    Peter Walton,
    Professor of Accounting,
    Open University Business School,
    Milton Keynes MK7 6AA, UK
    http://www.ft.com/cms/s/0/38e95f9e-1a3c-11dd-ba02-0000779fd2ac.html?nclick_check=1

  4. Michael F. Martin
    Posted Wednesday, May 7, 2008 at 12:34 pm | Permalink

    Here’s a brief sketch of a few implications that the most basic phsyics of analog circuit design would suggest to the Federal Reserve and SEC:

    http://brokensymmetry.typepad.com/broken_symmetry/2008/05/stable-market-d.html

    Could we send a few physics grad students to Bernanke to consult?

  5. Michael F. Martin
    Posted Sunday, May 18, 2008 at 11:34 pm | Permalink

    Separate from the need for accounting rules to require transparency (which prevents fraud) is the need for accounting rules to be consistent with the reality of how growth occurs within an institution. I understand this to be part of Peter J. Wallison’s point.

    I believe that the main problem with current accouting rules in this regard is that our entire understanding of economics, including our understanding of institutional growth, is frozen in time — we haven’t developed any simple, practical models for understanding how and why price fluctuates in time.

    I’ve been working out a simple model this purpose, which could eventually be useful in redesigning accounting rules.

    http://brokensymmetry.typepad.com/broken_symmetry/2008/05/schumpeterian-c.html

    I invite anyone interested to provide negative feedback on this model.

  6. Michael F. Martin
    Posted Wednesday, May 28, 2008 at 10:39 am | Permalink

    The key variable not measured by the current system of financial statements is frequency. Income statement and cash-flow gives a time-integrated picture. Balance sheet gives a snapshot in time.

    What is needed is a separate statement that shows the frequency of events important to the company — e.g., average time that parts are inventory, average time that receivables stay receivables, etc.

    You could ask why if this is important, hasn’t it already been done. First, it probably has by somebody. Second, you can partially reconstruct the information by looking at multiple financial statements side-by-side.

    The second is a kluge, and could be done better if you set out to measure directly in the first place.

  7. PTobback
    Posted Thursday, June 5, 2008 at 5:20 am | Permalink

    In my modest opinion, fair value is more informative to investors than historical cost. During the crisis, numbers were maybe less precise but fair value is also a ‘process’ throughout which firms are forced to think about the value and to report the most appropriate value. Concerning the accuracy of the number, there will always be a bias but standards such as IFRS 7 are also offering sensitivity analysis.

    Nevertheless, there should be an improvement to the measurement of (financial) assets in particular circumstances. Also in Belgium, stresstests of certain banks reported smaller losses than these under mark-to-market (this can be found in the annual report of the banks). Probably, fair value also contains illiquidity and uncertainty for the moment which isn’t related to the real fundamentals (see also Bank England’s Financial stability report and IIF press release 28 May).

    To finish, commercial banks as intermediares. Are there still clear borders between the different types of banks and between banks and financial markets? Maybe some commercial banks took to many risks and fair value is now reporting this. It is rational to take risks when the economy is booming (and when your paycheck is depending on short term gains) but maybe they went too far.

    So I rather think that fair value provides more transparancy towards investors. If they take the time to read the whole annual report, they know a lot more when things are reported under fair value compared to cost based accounting.

    Pieter Tobback,
    Belgian student
    (working on dissertation concerning fair value during the credit crisis)

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