Thursday, October 2, 2008

More accounting rule changes

As you may recall, I reported on accounting changes before.

Here is the gist:

With little notice, regulators at four agencies that oversee the nation’s banks and savings associations on Monday and Tuesday proposed a significant change in accounting rules to bolster banks and encourage widespread industry consolidation by making them more attractive to prospective purchasers. The regulators and the Bush administration have decided to resort to further loosening of the accounting rules to try to get the industry through problems that some experts have attributed in large part to years of deregulation.......

The action by the four banking agencies provides more favorable accounting treatment of so-called goodwill, an intangible asset that reflects the difference between the market value and selling price of a bank. The move is similar to a step taken in the midst of the savings-and-loan crisis that helped many institutions in the short run. Over the longer term, that decision increased the overall costs of the bailout after the government took away the goodwill benefits

Goodwill is a very problematic asset--it doesn't have much (if any) liquidation value and can't be sold by itself. No one will lend against goodwill. If capital requirements are really about ensuring that there is a solid fundamental core of assets backing lending operations, counting goodwill is quite questionable. The most troubling part of this is that we've been here before--in the S&L crisis, when the Federal Home Loan Bank Board (now OTS) permitted thrifts to count goodwill toward regulatory capital. The results weren't pretty, as counting goodwill toward capital masked institutional insolvency and permitted thrifts to get even more leveraged relative to real assets.

So accounting rules for goodwill got looser and it is easier for banks and investment "banks" to fudge, aka pull numbers out of their ass, under the "goodwill" entry.

Of course, the changes to accounting continue now; Reuters reports, Wed Oct 1, 2008:

U.S. securities regulators on Tuesday gave the financial industry a reprieve from marking hard-to-value assets down to fire sale prices, throwing a lifeline to an industry beset by strained credit markets and the latest round of bank failures.

In the new guidance, first reported by Reuters, the U.S. Securities and Exchange Commission reminded financial services firms that they don't need to use fire sale prices when evaluating their hard to price assets.

What does it mean, exactly?

The SEC's guidance on Tuesday, came on the last day of the third quarter for most U.S. companies, allowing them to incorporate the changes in their next round of financial statements.

In a document on the matter, the SEC reaffirmed that management's internal assumptions can be used to measure fair value when relevant market evidence does not exist.

What this means exactly is that we should focus on one sentence, which will clarify matters for us, non-experts: "the SEC reaffirmed that management's internal assumptions can be used to measure fair value when relevant market evidence does not exist".

Got it?

When there are no market prices to guide an accountant on exactly what is the price on a "hard to price" asset, he or she will go to the management of the company.

And what will the manager say the price is... lowball?

Or add a few zeros?

And before I attended a university, I thought that accounting was dry, boring.

I couldn't have been more wrong!

Modern Accounting is extremely creative and artistic!

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