Accounting’s Role as Cause and Cure of Crisis

Green Eyeshade.jpgCongress is signaling belief that accounting standards are a cause and may be a vital component of the cure for the current credit crisis. Slipped into Congress’s bailout bill is a short but potentially pivotal authorization to the Securities and Exchange Commission to suspend accounting standards applicable to many of the troubled assets at the heart of the credit crunch.

Those assets are reported at current market prices, which have declined precipitously and resulted in freezing credit markets. The bill envisions the SEC allowing these troubled assets to be reported at values higher than current market price, such as their value if held to maturity and collected in accordance with contractual terms. If the assets can be reported at higher values, banks face less pressure maintaining capital required by counterparties or regulations. But if reported at lower values, current pressures may continue or worsen.

Government transactions in these assets will be a basis for determining market value and thus how they are reported under fair value accounting standards. Government will wish to reflect lower prices in the name of protecting taxpayers; but higher valuations, by increasing apparent capital strength of enterprises continuing to hold related assets, may promote chances that the program succeeds in stabilizing credit markets. If fair accounting standards are suspended, it won’t matter what prices government support reveals. The upshot is that accounting standards may play a pivotal role in this policy discussion. Should they?

Critics say that fair value accounting is a cause of the credit market crunch. Amid stressed market conditions, they say, the result of reporting steadily declining market prices for assets is relentless downward pressure on those prices. This exacerbates those conditions in a downward spiral. Proponents of fair value accounting note that accounting is simply measuring previous decisions; fair value accounting promotes transparency and utility that maintains capital adequacy by making capital conditions transparent.

Both stances are reasonable. What ultimately divides them is a broader question: whether accounting should seek a modest role of pure and impartial reporting or be designed as a public policy lever that consciously seeks to influence market behavior. Congress is essentially directing this broad question to the SEC in Sections 132 and 133 of the bill , which authorizes the SEC to suspend, selectively by issuer or transaction, fair value accounting rules, and requires it to provide Congress, within 90 days, a fairly extensive study of them.

It will be interesting to see where the SEC comes out on these serious questions about the standards and their operation in difficult markets, including their role in the current crisis. A few general propositions seem clear. First, accounting is a system of classifying, measuring, aggregating and reporting. Second, the existence of fair value accounting did not increase the supply of capital allocated to residential home purchases with weak creditworthiness, expand securities markets that facilitated such lending, or induce wide scale defaults on related mortgages. Third, it did not trigger the chain of events that led to the current crisis.

Equally true, on the other hand, is that applying those accounting standards may have intensified the crisis. And, certainly, the accounting applicable to these troubled assets amid the government’s support program will bear significantly on its probability of success. Still, with few exceptions, including amid the energy crisis of the 1970s, accounting generally has not been used as a policy tool consciously designed to influence actual market behavior.

This orientation is reflected in how Congress has stayed out of the business of promulgating accounting standards and even the SEC, which can be prone to political pressures, has historically delegated this function to the politically insulated Financial Accounting Standards Board. In general, this is prudent public administration. In the specific case of this credit crisis, however, all tools may be needed. Accounting standards may be a vital one.

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