David M. Katz, CFO.com | US
August 6, 2008
Assume that we're talking about financial institutions (who support their debt with financial assets that could elect Fair Value under FAS 159), not non-financial firms (who may support debt with non-financial assets subject to other accounting models).
Posted by Michael Rand | Aug 11, 2008 5:04 PM ET
I had a few questions:
1) I don't get that in order to reduce the value of debt you'd have to write the equity off first. It is not necessary that equity value falls to zero before debt value is written off (in the ex ante sense).
Take for example a business of ex ante firm value = 110 (with face value debt of 100 and equity of 10). If you were to evaluate a change in risk where there were a 1/3 chance that firm value would go to 120, 100, and 80 respectively, you'd see that the firm value of 100 (avg. of 120, 100, and 80) is split between debt value of 93 and equity value of 7. In this scenario debt assumes some of the reduction in value. This, which was one of Black-Scholes basic conclusions, is because equity in a levered company works like a call option on the company's assets. As long as there is still potential upside, the equity will have value, even if the weighted payoff of the debt has gone down.
2) One of the comments that FASB made in response to these criticisms is that people are not looking at the issue holistically. If there was a reduction in creditworthiness resulting in a gain, wouldn't that mean that the fair value of assets have gone down even more than the fair value of the debt (i.e. equity has been reduced), producing an even larger writedown?
I'm not saying it's necessarily appropriate to have one side of the entry hit the income statement by itself (that seems silly). So perhaps this is an example of FAS 157's selective application being misguided. But I could imagine a world in which entities are marking both sides (assets and liabilities) to fair value that makes a lot of sense.
Then again, if the accountants are valuing the company, what's the investment community left to do?
Posted by Michael Rand | Aug 11, 2008 7:37 AM ET
I put all of this into the "strange but true" category of life on Wall Street ... like Bear Stearns building and selling billions of dollars worth of CDOs that no one at the company could understand.
Is it any wonder that the economy is so shaky?
http://tinyurl.com/5tmmm2
Posted by Paul Conley | Aug 7, 2008 11:38 AM ET
The fair value phantom will likely create the next accounting scandal. The Cash Flow Statement is likely to become the only relevant financial statement as cash flow is the only tangible measure of a company's success or failure.
Posted by Richard Connelly | Aug 7, 2008 11:06 AM ET
Well folks this is just the beginning; nobody cares about reporting the econimic substance behind a transaction of series of transactions, but simply what one can "get away" with. How can one "profit" from a situation when clearly the inherent and real risks and hence liabilities have intensified.
Posted by rick macchiarulo | Aug 7, 2008 10:07 AM ET
Paragraph 6 of FAS 157 clearly states that the fair value is the price that would be recieved to sell an asset or paid to transfer the liability to someone else.
This FASB Statement very clearly states that this is the price that you would have to pay to get someone to assume your liabilities. I would like to know where Ambac can find someone who is willing to pay less than the present value of the obligation to take their liabilities on because of their credit risk. My credit score has dropped and I want to sell these people my mortgage for less than I owe.
There is absolutely no way, in any market, that anybody in their right mind would do this. How can they state that their liabilities are being marked to a fair value? If anything, they should be marked up, not down, because the risk must be assumed to be the same. If I am just as unlikely to pay the debt as the person I am assuming it from, they better pay me as much or more than the present value to assume it.
I think people are looking at fair value incorrectly from the liabilities side. You cannot mark this to the price they would pay to purchase this as an asset. Of course, I would pay less if I was to purchase this from the people whom Ambac owes, but that is the wrong viewpoint. How much would Ambac have to give someone to take their liabilities from them? That is definitely not less, and likely more than what is currently owed because of the credit risk.
Do they know the difference between an asset and a liability? This is simply bad accounting and a bad interpretation of FAS 157.
Posted by Steven Wickman | Aug 7, 2008 9:45 AM ET
While there can be no doubt that economic reality must underlie accounting in the same way physics underlies engineering, there are also practical considerations of technical and human reality to those applications.
In an ideal world, fair value would be objective and indisputable. We don?t live in an ideal world. The theoretical must be balanced against the feasible, the practical and the episteme against the techne.
The very idea that an increasing the probability of default could improve reported financial results isn?t as the article states ?counterintuitive?, its insane. It make a mockery of the very concept of ?earnings? being the result of the production of value to an informed and willing third party sufficient and significant enough to cause that party to willingly offer/relinquish something of value in exchange.
The logical extreme of paragraph 15 of FASB 157 is recording a gain prior to filing for bankruptcy or an individual writing down a personal debt due to an increased likelihood of default based upon him or her being criminally indicted and subject to prosecution.
Interestingly, although the article details yet another example of how FASB?s most recent efforts to rush to novelty are quite capable of producing impractical, distorted, disordered and irrational results, the recently issued FASB 162 (May 2008) explicitly removed the ?Rule 203? exception from GAAP, which allowed departures from GAAP when the application produced just such misleading results, on the basis that it was rarely applied, addressed to the auditor, (unlike IAS 1, whose exception they did NOT adopt in spite of ?convergence?) and dismissed allowable departures with this vainglory: ?Therefore, an entity cannot represent that its financial statements are presented in accordance with GAAP if its selection of accounting principles departs from the GAAP hierarchy set forth in this Statement, and that departure has a material effect on its financial statements.?
If there?s something more psychotic than the arrogation of power by an organization simultaneously attempting to remake its landscape while publicly expressing indifference to a desire for its own continued existence, then I?d like to see it.
Unfortunately, while generations of accountants have been programmed to believe FASB is a body of indisputably wise sages, promulgating rules after the most careful and sober deliberations, the track record of the past few years suggests something else.
Posted by Super Heater | Aug 7, 2008 9:40 AM ET
Fair value disclosures are reasonable requests and provide the investors with assistance in determining the value of the company being reviewed. It has no business being used in the score cards (read Financial Statements) of the company performance. Actual transactions leading to realized gains and loss are all that should be used in keeping score of a company's performance. Not some theoretical economic impact that can swing so much in a month's time (Ambac admits to a $2 billion swing).
Posted by Charles Smith | Aug 7, 2008 8:55 AM ET
Mark your own liabilities to market? Does that mean take a discount for the fact you might not pay your debts?
Fine. But only AFTER you market your own equity to zero! Because that's the necessary precedent to paying less than 100? on the dollar.
Posted by Robert Arvanitis | Aug 7, 2008 8:47 AM ET
Copyright 2011 © CFO Acquisitions LLC. All rights reserved Privacy Policy Site Map
