The big financial news this week was the G20 summit in London. This is understandable since most of the world’s leaders were present including President Obama. In the news this week it was also reported that the stock market actually appreciated in value during the month of March but it is difficult to determine why this rise in the markets occurred in light of rising unemployment and declining consumer confidence. So we must ask ourselves this question, exactly what caused the gains in the market for the month of March? One contributing factor may be the change by the Financial Accounting Standards Board (FASB) to FASB 157. For the non-accountants out there let me take a moment to explain FASB 157 and why it was implemented in the first place.
The purpose of financial statements that are prepared and audited by accountants is to provide a fair representation of the company’s financial position. The balance sheet provides a snapshot of the company’s financial health as of a certain date, usually the end of the accounting period. This financial report is called a balance sheet because the total assets on the report must equal the total of liabilities plus equity.
In order to insure the accuracy of the balance sheet as well as the other components of the company’s financial statement, companies routinely conduct independent audits. In fact publicly traded companies are required by law to have such audits. The purpose of these audits is to provide independent validation of the company’s financial statements. For the balance sheet, this means validating the value and existence of the company’s assets, liabilities, and equity.
FASB 157 focuses on the valuation of liquid assets such as marketable securities held by a company. The purpose was to insure stockholders of a company that the corporation was not over valuing the marketable securities on its balance sheet in order to inflate the equity or value of the corporation as this could cause the stock value of the corporation to be over valued on the market. When a bank issues a mortgage to an individual or business, the loan represents a marketable security on their books. They can either hold onto the security or sell it to someone else. For example, I have lived in my present home since 2003 and three different institutions have owned my mortgage. Since these mortgages fall under the definition of marketable securities, banks have been required to use FASB 157 and adjust the value of these assets to their market value each accounting period.
However, when the market for a security becomes inactive, what should the basis be for valuing the security? This was the purpose behind this weeks attempt by FASB to clarify FASB 157. Under the previous interpretation, an inactive market was treated the same as a distressed market. Under this interpretation the values of the securities in this inactive market were essentially worthless and banks were required to write them off. For banks that had invested heavily in the sub-prime market, this write down was devastating, causing some banks to fail, and placing many others on the verge of failure.
The government, desirous to preserve the integrity of the banking industry, responded with the bailout bill back in September. The intent of this bailout was to provide distressed banks with coverage for the massive write-offs they were required to take. However, there was no over sight as to how the banks handled the money and was later revealed, the banks that received this government bailout actually used to money for other purposes such as remodeling offices and the paying of bonuses. These banks still finding themselves in financial jeopardy are even discussing with the government their need for additional bailouts. We must now ask the question, why should we even think additional bailouts when they did not work the first time.
This weeks ruling by FASB makes it possible for banks to use their own judgment in valuing these distressed assets leading to fewer write-downs and reduced losses. It is believed that this change in an accounting rule will lessen the need for more government intervention through bailouts. The increases on Wall Street seem to reflect the markets pleasure with this change.
However, as an accounting professional, I have some reservations regarding this change. Since the goal of financial reporting is to fairly present the company’s financial position, we must question the fact that management of a bank will have the ability to value a large percentage of their assets using their own judgment. In order to preserve their jobs, executives in the bank may be motivated to present the rosiest of pictures for the financial status of the companies they manage. Stockholders in these companies should rightly question whether these assets are properly valued when analyzing the financial statements.
These assets did not become worthless due to some accounting rule. They became worthless because banks issued these risky mortgages without doing their due diligence to determine if the borrower had to ability to repay the loan or if the asset being held as collateral was properly valued. If these banks had done this, they may not have made these risky loans and would not find themselves in the position they are now in.
All decisions have consequences. These consequences may even be terminal for some banks and very painful for others. However, even though some banks may fail, the banking industry as a whole will not. The FDIC insures deposits at these failing banks up to $250,000 per account so the depositors need not worry. They will receive their money and can then deposit it in one of the more responsible banks that remain or in a new banking venture started by persons who are more responsible and ethical.
These irresponsible banks will go away eventually. The sooner they do, the quicker we can recover from this recession. I urge my fellow accountants working in the banking and financial industry, and auditors who audit these institutions to exercise due diligence. It is important that these accountants exercise professional skepticism when evaluating the models used by management in valuing their marketable securities. The stockholders of these companies are depending on these accountants to insure the fairness of the company’s financial position as reflected in the financial statements. Let us not disappoint them by letting management inflate the value of these assets.
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