How Fair Value Rewards Deadbeats

Opponents of mark-to-market accounting complain that some companies are making silk purses out of sows’ ears.
Tim Reason and David KatzJuly 9, 2008

Panelists of a Securities and Exchange Commission roundtable on fair-value financial reporting on Wednesday clashed over an accounting provision under which a company can boost its reported earnings by becoming less creditworthy.

In the provision, paragraph 15 of standard number 157, the Financial Accounting Standards Board’s controversial new stricture on fair-value accounting, FASB states that the fair value of a company’s liability must reflect the risk that the company won’t pay it back. Thus, as the risk that companies won’t pay back their debts rises, their reported liabilities actually decrease–and may even provide an earnings boost.

Illogical as the provision sounds—and it sounds illogical to many—quite a few companies are already making hay by using it. The rewards for potential deadbeats can be large, according to a Credit Suisse report on the first-quarter 2008 10-Qs of the 380 members of the S&P 500 that have either a November or December year-end close, the first big companies to adopt FAS 157. For the 25 companies with the biggest amounts of liabilities on their balance sheets measured at fair value, widening credit spreads—an indication of a lack of creditworthiness—spawned first-quarter earnings gains ranging from $11 million to $3.6 billion, according to the study.

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Not all companies are so hot on the paper gains. One speaker, Joe Price, the CFO of Bank of America, found the provision too divorced from economic reality. “The inability to monetize this type of gain is very troubling,” he said. “We personally have not availed our self of it for generally that reason.”

The most vehement of fair-value’s opponents on the panel, James Tisch, president and chief executive officer of the Loews Corporation, was prompted by the discussion of the provision to launch a tirade against the whole idea of providing fair values for liabilities. Speaking “In the name of those of us who have been in the business for a long time and believed the purpose of the income statement was [to show] how the company had performed based on the variables it could affect,” Tisch argued that the notion of a company marking its own debt to market is absurd. “It is going to destroy the notion of the income statement and make it unusable for investors who just want to see how a company did for a quarter.”

How, asked Tisch, could a company monetize the fair value decline in its debt for a quarter when there was “no doubt” the company would have to pay back the debt? “In a philosophical sense, it makes sense,” he said, “but it undermines the purpose of income statements and makes no practical sense.”

Acknowledging that its virtues are hard to grasp, the defenders of including credit risks when marking liabilities to market argued that a broader use of fair value that accounts for assets and liabilities in tandem would clarify all. “Is it confusing?” Kathy Petroni, a professor of accounting at Michigan State University, asked of the provision. “Yes. Is it representationally faithful? Yes.”

To be sure, she contends, when a company’s credit risk rises, its share price is likely to fall accordingly. That suggests why the earnings boost created for some companies by the inclusion of nonperformance risk in fair-valuing liability seems so counterintuitive. But a fuller use of fair value would show that “the loss on assets would certainly outweigh the gain on the liabilities,” Petroni says.

FASB member Thomas Linsmeier agreed. “If the full balance sheet is mark to market, you have much greater loss on asset side, and you reflect a small gain on the liability,” he said.

Currently, however, corporations aren’t required to fully mark their balance sheets to market. “That raises question of whether partial fair-value gain [as a result of including nonperformance risk] is problematic,” he observed.

But savvy investors can see that potential problem as an opportunity for a deeper glimpse into the underlying economics of a company. If a company’s asset loss is much smaller than a liability gain recorded as result of a rise in its credit risk, that should “give investors a sign,” said Linsmeier. “The gain on the liability side should not be treated as a gain, but [as a signal of] losses on the asset side.”

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