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With Wall Street responding favorably to FASB’s mark-to-market accounting rule changes, the question becomes: what will the long term effects be? After much speculation and debate, FASB decided to loosen the mark to market accounting rules in FASB 157, allowing balance sheets to stray away from the strict fair value accounting that is believed to have intensified the market turmoil. Critics of fair value felt, in a quick summary, that with toxic assets like the mortgage backed securities having to be written down to next to nothing, the banks’ reserves were to be hit dramatically. This destroyed the ability of banks to lend, causing companies to not be able to borrow, which caused the economy to down-spiral into a global recession. Instead, banks now have the freedom to value assets using their own valuation models, at what they feel they would be worth under “normal” market standards.

Values will be based on what the assets would sell in an “orderly” transaction in a non-distressed environment. This may turn out to be quite dangerous, as the banks are now able to give a market value for toxic assets with no actual market. Banks are now also able to only have to write down part of their impairments if they plan on holding the asset to maturity. In the traditional mark to market rules, an asset that suffers an impairment would have to be written off completely, accounting for the write-down as a realized loss. With the loosening of rules by FASB, assets will only have to be partly written off due to impairment. This does not show the true value of the asset, resulting in less transparency within the balance sheet. Anyone who follows the markets knows that losses have occurred, and knows the “garbage” is still on the balance sheet, hidden or not. This will ruin the confidence investors have in their assessments of the risks involved in a bank. With the banks able to hide these markdowns, how can we have the trust to buy?

Auditors’ Reactions

It will be interesting to see how auditors portray the new standards, especially since there was a strong opinion among financial reporting directors that auditors took fair value accounting too far, forcing firms to provide proofs that the assets were indeed valued fairly. Auditors are known to be very conservative in their opinions of the financial statements of a company to prevent lawsuits or damages to their own reputation. That being said, the accounting changes are another way for banks to paint a better condition of their statements. Auditors will be stricter regarding their valuations, especially since the split in losses will be difficult to verify. More experience is necessary for auditors to feel comfortable signing off on the banks’ valuations using the new standards, leading to the possibility of some banks still using fair value accounting to avoid complications.

Going Forward

Going forward, it is tough to say how the accounting changes will affect the capital markets. With the common belief that reactions due to speculation were reflected in the markets before any changes were even made, there may not be an impact at all. Many say confidence will be restored in the markets, since investors know banks will be able to almost “hide” losses using their own valuation models. Also, even though an impairment occurred, firms will not be forced to write off the entire impairment, so the balance sheet won’t be hit nearly as hard. The true health of the firm will not be accurately shown, leading to much less transparency within the statements. This is surprising, since the recent goals of the FASB has been the push for more transparency. To big bankers, it’s exactly what they’ve been pushing for, as banks will be able to recover billions of dollars in losses. So far, Wall Street has reacted favorably to the new standards, with analysts predicting that some banks will increase quarterly earnings by up to 20 cents. However, it has become all too familiar to see firms valuing assets above their true market value. This may in fact prove to be the completely wrong move by FASB.

What To Look For

Look for second quarter earnings to reflect these changes. Expect big banks to report higher earnings as a result, while other banks stick to the traditional mark to market rules, and possibly suffer from the disadvantage. For global multinationals, the convergence of US GAAP and IFRS will definitely have an impact on the long run, as the IASB is considering also loosening it’s mark to market and impairment standards. If this does in fact happen, global markets will most likely react just like the US markets have, and will cause these standards to be a permanent fixture in the balance sheet. Other countries’ standards outside the IFRS are also considering following suit. Canadian banks are pushing for the adoption of the U.S. mark to market rules, so as to not have a disadvantage in the North American capital markets. The global recession has forced the notion that all countries should be under the same accounting standards (IFRS), so it is necessary for the IASB and FASB to agree, and have a joint approach regarding the financial crisis. This will prove to be a prominent evolution in accounting, especially after the G20’s call for the reduction in the complexity of the financial instrument accounting. Immediately after FASB announced the changes in early April, IASB began a 30-day discussion process to ensure the meeting of the urgent demands of the issue. IASB meets April 20-24, so look for changes to IFRS that will impact the global markets in a similar manner to FASB’s impact on the US markets.

-Phillip Harper

Disclosure: None

Source: Mark-to-Market Changes: Looking Ahead