Accounting (1)

The past week has brought a plethora of news stories related to accounting rules.  FASB announced last week that it was thinking that regulators should “decouple” their analysis, especially when it comes to capital accounting, from the reporting provided to investors.  The CFA Institute, for one, isn’t mincing words about how they feel –

“The purpose of financial reporting is to convey the results of the company,” said Sandra Peters, the director of financial reporting for the CFA Institute, an investor advocacy group. “It is not to assure the company stays around.” 

It’s nice to know that someone has a clear picture of what they expect from financial reporting.  But it’s become increasingly clear over the past year that the name of the game for financial reporting is just that – a game.  Exhibit A would be the SPV’s that were classified as “bankruptcy remote” – there’s a non-operative term if we’ve ever heard one.  (A “no-op” for the computer geeks out there). 
In addition to SPVs and related nonsense, some of the discussion refers to that perennial favorite, “Mark to Market” vs. “Fair Value”.  There are so many problems with this whole issue that one almost doesn’t know where to start.  The two that leap to the front, however, are:

• “Fair value” accounting means that the market isn’t correctly valuing the asset.  That may be the case, but if it is, please don’t claim to be a believer in efficient markets with the one exception being the assets on your balance sheet.

• “Mark to Market” for thinly traded securities has always been as much of an art as a science, but the proliferation of securitized instruments based on heterogeneous pools of underlying assets has happened too fast for those practicing the art (or the business processes) to do much more than scramble behind, trying to keep up.

A recent NY Times article lightly touches on the biggest issue – capital arbitrage – which is behind what I consider to be the true Naked Emperor here.  Capital arbitrage is the term used to describe the manipulation of a bank’s balance sheet through securities issuance and the creation of various off-balance sheet entities so as to enable a bank to evade specific regulatory capital requirements.  There are echoes here of the “principles-based” vs. “rules-based” regulatory debate that’s gone on between the US and European cognoscenti for the past couple of decades, but to my mind the evidence points pretty strongly to this discussion being irrelevant in practice.

The simple fact is that, based on the evidence, it appears that corporations will get away with whatever they can – and that there is no one personally liable to take the heat for questionable practices.  As one industry participant asked me outside of a discussion forum a couple of months ago – “Where’s the perp walk?  These guys had to know something was crazy wrong – or else they should have been canned for being incompetent.  How come nobody’s been arrested?” This comes from a gentleman who has spent his entire career on Wall Street.  It seems that much of what happened leading up to the credit crisis was legal, if stupid from an organizational survival point (what Greenspan was shocked! to acknowledge as a possibility).  But it is clear that “gaming the system” is a common goal of managements across the industry – just because something can be done doesn’t mean it’s smart or the best thing for those involved.  But it is what we now appear to consider normal.   It really doesn’t matter what the rules for financial reporting are, if the common understanding is that they function only as a guide to what you might get in trouble for – if you get caught – and that the goal is to report numbers that represent what you think people want to see instead of the current health of the business.  That’s a game, not ethical business practice.  About as realistic as “bankruptcy remote” SPVs.