By Holly A. Bell
Remember Enron? Apparently the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) don’t. While the Enron scandal had multiple layers of both illegal and unethical behavior, at the heart of it all was Jeff Skilling’s insistence on using mark-to-market accounting techniques. This was not standard accounting practice, but an exception that was granted to Enron. Now the FASB and IASB are considering making mark-to-market accounting the standard for all businesses.
Mark-to-Market Accounting vs. Traditional Accounting
The valuing of assets on balance sheets has traditionally been very conservative by design. Assets are recorded at their actual (explicit) cost (what you paid for them) rather than their current (implicit) market value. If you bought land for $120,000 and that land is now worth $1.5 million dollars, the $120,000 value is the asset value on your balance sheet. One reason for this method is that these assets are considered “sunk costs” that really aren’t relevant to investors as they are already in place. Cash flow is generally what investors are interested in. Any current market value is only a “best guess” and is frankly irrelevant unless you plan to sell the asset. Unless investors are looking at the liquidation value of the company (which is a valid thing to consider), I’m not certain it would be all that valuable.
Why Businesses Want Mark-to-Market Accounting
It’s easy to see why businesses would want mark-to-market accounting. If you are a company like Wal-Mart and you own a lot of real estate, the asset value of your company would increase exponentially. Of course this doesn’t apply exclusively to real estate. Other assets like inventory would also be impacted. There are also several reasons why banks would like to see assets and liabilities treated differently as it would significantly impact their earnings. And of course banks are looking for any means of appearing more financially stable.
Enron Revisited
Mark-to market accounting allowed Enron to book not only the explicit value of their assets (like power plants), but also the entire estimated value of the anticipated revenues that plant would produce. While this method also requires companies to adjust those values on their balance sheets to reflect fluctuations in the marketplace or anything else that might change the values, it is again just someone’s “best guess” and there is little incentive to adjust value downward. See any potential problems here? In Enron’s case they were showing high asset values, but had little cash flow. Without cash flow, businesses will fail. The good new is, this is where the market value of liquidating assets might be good to know.
An Alternative
Since there is really no good way to prevent companies from overvaluing assets or accurately estimating the value of anticipated revenues from contracts utilizing those assets, why don’t we leave the traditional accounting standards in place? They provide a conservative estimate of value and a better way for investors to calculate earnings expectations. This doesn’t prevent companies from also calculating their financial assets and liabilities using mark-to-market accounting practices as a supplement to their quarterly and annual reports. In fact, I would love to see both methods utilized, as more information is always preferable. Information on current prices is valuable, but we can minimize the limitations of either system by providing the information contained in both methods.
Great post Holly.
Also Holly, it just seems that FASB accommodates the big banks and institutions.
I wonder how many lobbyists ‘push’ the board for changes or accommodations on a regular basis.
I find the MTM rule simply amazing, amazingly underhanded.
Basically allowing for the valuation of assets to be based on a market value/price, determined within an orderly or ‘normal’ market rather than a forced liquidation value in a down or depressed market.
This is one of many jokes of the decade in valuation practice.
It is equivalent to valuing non-performing/foreclosures/abandon properties in various states of disrepair and then assigning a “Prospective” value only rather than a proper ‘As Is’ value.
While this does go on in real estate, it not a very common practice and usually banks do not like to put the terms of a loan strictly on a ‘prospective’ value. Funny how it seems this is an acceptable practice for financial institutions or corporations, but not for the average person.
@ Geo:
Then when those forced liquidations happen, because the assets sold below perceived \’normal\’ market values they drag market values down with them hurting us all. We see this in our own home values. It used to be that foreclosed properties were never considered when a property was appraised. Now because of all the forced liquidations, they are required to consider nearby foreclosures when appraising market value of properties that are not distressed or in forced liquidation.
Why the FASB allows some companies (like JP Morgan & Enron) to use MTM smacks of corrupt practices. Either big banks are solvent, or they\’re not. Let\’s not confuse credit with capital like our government does.
Are you suggesting that if I were to prepare a blance sheet of my assets and liabilities, I should value the house we bought in E. Lansing, MI 7 years for $150,000 and now worth less than $90,00 — due in large part to nearby foreclosure — at $150,000? Getting rid on M to M to me is like shooting the messenger.
@ Elliot:
I am simply saying there is incentive with MTM to overvalue assets and that liquidation value is lower than market value. When assets are overvalued they create bubbles that eventually burst.