As If Accounting

Do reasonable Americans today regard housing markets, credit markets, stock markets or collectibles markets to reflect accurately the fair value of their homes, corporate bonds/equity and collectibles? My guess is that a large number could honestly and in good faith say “no, that they do not,” whether correctly or incorrectly. Many might say instead that at least some of these markets are at least periodically distressed (or even inactive in the case of collectibles and some housing markets) and that related prices, if any, “really represent distressed sales.”

If so, according to the logic of new accounting rules the country’s independent accounting standard setter adopted last week, valuation of these items may not accurately be ascertained by using recent comparable home sales or trading prices for corporate debt and common stock or auction sales of collectibles. Instead, they could be ascertained by reference to the owner’s own judgments about what those assets would sell for in an “orderly transaction” and “active market.”

The accounting body (the Financial Accounting Standards Board) last week gave analogous authorization to corporate America (and FASB’s London-based counterpart is being pressured to follow suit). In its plain English version of these new rules, FASB says they are designed “to figure out fair values when there is no active market or where the price inputs being used really represent distressed sales.” FASB continues: “The objective is to reflect how much an asset would be sold for in an orderly transaction (as opposed to a distressed or forced transaction) .”

Although the rule imposes technical restrictions on use of this judgment based valuation, by its logic, if not its sometimes technical language, if people who own homes in economically distressed neighborhoods and debt obligations or common stock of, say, AIG or Citigroup, or other distressed companies, or fine art that simply can’t be sold today, their own personal financial statements may be more accurate if they reflected assumed exchange values in “orderly transactions” rather than the effects of related “distressed” conditions or “inactive markets.”

Accordingly, a large number of people whose net worth appeared to have declined precipitously from say September 30, 2008 to March 31, 2009, can revalue their assets upward. Just because your shares in Citigroup or AIG trade for a few hundred pennies or less, you are entitled to make your own different judgment about what they are really worth. Just because no homes have sold in your region except at fire sale prices half what they were a year ago, you may assume that your home is worth the amount for which your next door neighbor sold her comparable place a year ago absent the distressed conditions. Collectibles can be valued based on an owner’s judgments, even if no one would buy the items now.

On the other hand, of course, even if Citigroup values its assets using a version of this as-if method of accounting, I doubt it will give high credit scores to credit applicants using analogous methods. For me, I think I am better off recognizing that my net worth has fallen nearly by half the past half year, than pretending it is worth twice what current conditions manifest. That remains true even though I also believe that some assets may be selling at prices representing some discount to their intrinsic value.

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3 Responses

  1. A.J. Sutter says:

    Thanks for emphasizing this issue. BTW, what’s the impact of the new accounting rules on the “stress tests” for financial institutions? Will “as if” also equal “stress relief”?

  2. Frank says:

    A very valuable perspective. I am afraid that Simon Johnson is right about this trend:

    “Excessive inflation is a typical outcome in oligarchic situations when a weak (or pliant) government is unable to force the most powerful to take their losses – high inflation is, in many ways, an inefficient and regressive tax but it’s also often a transfer from poor to rich.”


    If the buying power of my 401K account and savings account is the price it could sell for now, whereas the buying power of the banks is forever propped up by these rule changes, they have much more buying power relative to me than they would without the propping up.

  3. ohwilleke says:

    Is this so new? Most definitions of fair market value, for example, in tax law, say something along the lines of “the price that a willing buyer would pay a willing seller, under no compulsion or undue influence.”

    One could, for example, expressly tie financial accounting value to the stock market valuation of the entity valued, but that would defeat the purpose of having financial accounting statements add information to the equation, rather than simply reflecting what is already known by the trading public. Bootstrapping asset value from stock market value is part of what created the toxic asset problem in the first place, because in practice, many collateralized debt obligations were valued based upon the price at which credit default swaps in those securities were trading, rather than from the fundamentals involved in the underlying asset.

    One also suspects that one could back an undistressed price under this definition out of a current foreclosure sale/short sale/distressed sale value with some sort of “distressed sale discount” valuation comparable to the cottage industry of assigning minority interest and lack of marketability discounts to assets. If some appraiser’s data set shows that foreclosed properties typically sell for 80% of FMV or $30,000 less than FMV or whatever, one ought to still be able to use foreclosure sales to reasonably estimate undistressed values, without bootstrapping.

    In the end, the purpose of financial accounting is to facilitate good decision making in ownership and financing transactions. Valuing mark to market assets based upon undistressed values, which can in turn be compared to current distressed values (thanks to the wonders of accounting statement footnoting, the real genius of the FASB system), with an undistressed asset valuation should, therefore, help decision makers determine how material the difference between an enterprise’s value as a going concern, and an enterprise’s value in a distressed asset sale — the key consideration for any entity considering steps like an FDIC take over, a bailout, or a Chapter 7 or 11 bankruptcy.

    Certainly, the job isn’t easy. It is even more difficult in the case of a complex asset like a CDO or a CDS. But, this approach should be more stable and less subject to manipulation than a price based upon a thinly traded or exceptional distressed sale. Reliance on either of those measures as a matter of FASB rule would be almost an invitation to market manipulation.