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The Obama Administration has moved swiftly over the past two months to reassure the markets it is doing everything it can to stabilize the financial system: stress-testing banks, planning auctions to buy their questionable assets, making capital available to the ones that need it. Have accounting rulemakers thrown a wrench in the works?
After intense pressure from lawmakers and some factions of the financial industry, the Financial Accounting Standards Board (FASB) voted on Apr. 2 to make it easier for corporate management to value assets on their balance sheets with less regard for market prices. The board, which sets U.S. accounting policy, was cheered on by the banking sector and pressured by Congress.
The move may make life easier for financial institutions, letting them ride the markets' gyrations with less risk that regulators will demand they raise funds or face closure. But at the same time, it could well cloud investors' insight into how well the banks are really doing. And some observers worry the new rules will also give banks less incentive to cleanse their balance sheets by getting rid of risky assets through the Treasury's new auction program, unveiled late last month.
The issue centers on a long-running but normally obscure debate over "fair-value" accounting—previously the province of financial wonks but now the focus of furious lobbying and heated congressional hearings. At their heart, fair-value principles say asset and liability figures on a company's books should reflect their real-world value. That typically means marking them up or down to market prices whenever possible, on the theory that markets provide the best measure of value.
But banks say the financial crisis has made mincemeat out of those mark-to-market rules: Many securities are trading thinly, if at all—particularly those backed by residential mortgages and other loans now seen as risky. The trades that do occur close at fire-sale prices that don't really reflect the assets' true value, they argue. Their solution: Let bank management come up with more accurate assessments. And in a fiery House hearing last month, lawmaker after lawmaker drove home the same point to federal regulators and the chairman of FASB. "Don't make us tell you what you have to do," Representative Michael E. Capuano (D-Mass.) warned FASB's chairman in a hearing last month.
Investors counter that, imperfect as market prices can be, they're more reliable—and certainly more transparent—than black-box estimates made by management. They say the FASB's technical changes give bank management too much leeway, especially with the strong incentives they have to arrive at too-rosy estimates. The upshot, critics argue: Investors will lose even more confidence in banks' financials, exacerbating the very doubt that has helped drive the financial sector's rout in recent months. "It's downright Orwellian to protect the public. This 'oversight body' would blind them from the mistakes made by financial institutions by making accounting less transparent," Jack Ciesielski, editor of the Analyst's Accounting Observer, fumed on his blog.
This could be a brief tempest if the Obama Administration succeeds in auctioning off as much as $1 trillion of the dodgy assets weighing down bank books. Once banks are cleaned up and credit markets resume their normal function, market prices will be easier to come by, and presumably more favorable to banks.
But that may not happen if banks suddenly have an incentive to retain their assets in the hopes that markets recover before they have to sell. The new rules "may also result in entities not willing to sell financial assets because they may realize a loss, as it will be more beneficial to carry assets at the higher 'mark-to-model' value," warned the Center for Audit Quality, a nonprofit auditing think tank. In other words, if the rules let banks hold on to the assets without taking a hit to net income for market conditions, they might be less eager to sell now. Selling into a down market, after all, locks in losses—no matter how FASB tweaks mark-to-market accounting.
"The concern is it's really got the potential to undermine what Treasury's trying to do, which is get the assets off the books," says Jay Hanson, national director of accounting for audit firm McGladrey & Pullen.
In making its final decisions, the accounting board modified one of its two proposals, ameliorating the harm it could cause in the eyes of some critics. But accountants, auditors and investor-advocates continued to blast the FASB for the rushed changes, including the CFA Institute, an accountants' group; the Center for Audit Quality, an auditors' think-tank; and the Investors' Working Group, a panel formed to rethink financial regulation and headed by former SEC chairmen William Donaldson and Arthur Levitt.
"This is a huge mulligan for banks with junky securities," Ciesielski, the accounting analyst, said on his blog. Others who had been concerned about the FASB's moves were mollified, however, saying additional disclosure requirements that the board imposed Thursday would actually provide more details about asset quality than they have now. "Investors get what they want with more information," Hanson says. "I'm satisfied with what they did today."
The American Bankers Assn. and the U.S. Chamber of Commerce lauded the move as "providing more accurate estimates of market values," and the Securities Industry and Financial Management Assn., which represents investment banks and securities dealers that have interests on both sides of the debate, also praised the changes.
Francis is a correspondent in BusinessWeek's Washington bureau.