Accounting & Tax

Mark-to-market’s Liability Lag

A new study of the S&P 500 finds a whopping mismatch between assets and liabilities subject to fair value.
S.L. MintzJuly 10, 2008

The scramble to implement fair value accounting rules has launched a thousand companies in as many directions, subjecting assets and liabilities to market valuations whether or not markets exist. The ramifications resemble guideposts to some observers, futile and dangerous exercises to others. But in an era of proliferating derivative and asset-backed securities, special purpose investments and other financial instruments subject to volatile global forces, both sides agree that the reliability of U.S. financial reporting hangs in the balance.

Even post adoption, mark-to-market rules under FAS 157 provoke profound disagreement in upper echelons. Panelists at a roundtable on fair value accounting standards, hosted by the SEC yesterday, sparred over implications. “If you are holding a position, you should know its value and how to apply that information,” said Goldman Sachs managing director Matthew L. Schroeder, who said illiquid markets just require harder work to discern fair value. “We don’t subscribe to the notion that there are no prices out there.”

With elusive insurance company assets and liabilities under a microscope, Loew’s Corp. CEO James Tisch said he understood the principle but mainly saw confusion in adjustments to income spawned by fair value accounting. “In a philosophical sense that may make sense,” he said, “but to me it undermines income statements and has no real practical use.”

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The fair value dustup even made national television on July 7. It surfaced during the Charlie Rose program, when JPMorgan Chase CEO Jamie Dimon summarily rebuffed prominent critics who attribute much of the recent market upheaval to needless mark-to-market accounting. Said Dimon, “It was not an accounting issue, okay? Most of the loss that people have taken will be realized.”

An exhaustive new research report by Credit Suisse attempts to get to the bottom of the debate now swirling around fair value accounting. It claims that evidence gleaned from 380 companies in the S&P 500 that have adopted fair value measurement per FAS 157 supports a clear verdict: marking assets and liabilities to market value clarifies economic reality for all stakeholders.

“We can hear the complaints already, you’re crazy, that would make earnings too volatile,” say authors David Zion, Amit Varshney and Christopher Cornette. “Too bad, that volatility is real, even if the company has no control over it; we would prefer to see the financial statements reflect real economic volatility rather than a false sense of stability.”

Do not blame the dizzying rigors of fair value on zealous accountants, write Zion and his colleagues. Instead, an ugly combination of factors have steadily pushed matters to the brink — and over it, in the case of subprime loans. “The real problem was overexposure to certain assets, poor risk management, misunderstood mispriced risks and lots of leverage.”

Familiar causes have fueled surging momentum for fair value accounting that companies used to apply at managers’ discretion. The Credit Suisse report concentrates instead on consequences of calculating exit values for assets and liabilities — that is, prices they would fetch in an orderly market or the closest possible proxy for one. The new rule applies regardless of good health or impairment, even when no current or foreseeable need exists to find buyers.

Key findings highlight an overarching mismatch between assets and liabilities subject to three tiers of fair value. Companies in the Credit Suisse study claimed $28 trillion in assets, all told, with 34 percent, or $9.5 trillion, marked to market. But of a total of $24 trillion in liabilities, a much smaller slice, only 11 percent, were marked to market.

About a fifth of mark-to-market assets and a quarter of the liabilities occupied level 1, for widely traded securities with readily visible market prices. Slightly more than two thirds of fair values landed on level 2, for valuations resting on proxies with similar characteristics. Level 3, reserved for the most elusive valuations, held 12 percent of fair value assets and 8 percent of fair value liabilities.

Taking close note of level 3, the report identified 294 companies where level 3 fair value assets make up less than 1 percent of total assets. However, it found 56 companies where level 3 assets exceeded 10 percent of book value. Overall, transfers help push level 3 assets to more than $1 trillion in the first quarter.

Notwithstanding a 25 percent jump in level three assets, the widespread impact of fair value thus far has been muted. At 125 companies, fair value assets exceeded 10 percent of total assets, while nine outliers marked more than three fourths of their total assets to market. At 188 companies, however, fair value applied to less than 2.5 percent of their total assets.

The financials sector records disproportionate impact, as should be expected. Still, in round one of fair value implementation (for companies whose fiscal years started after November 2007), health care companies reported nearly 20 percent of their combined assets at fair value followed closely by information technology, at 16 percent.

Owing to their complex assets and liabilities, Hartford Financial Services, Ameriprise Financial, Federal Home Loan Mortgage Corp. and Prudential Financial and other financials accounted for more than 95 percent of both assets and liabilities reported at fair value in the first quarter of 2008. Of thirty companies reporting fair value assets that exceed half of total assets, all but two were financials. On their aggregate balance sheet 44 percent of assets are reported at fair value, also the largest representation by far.

For investors, Credit Suisse asserts, “maybe the most significant impact of FAS 157 is that it requires companies to disclose more information about the reliability of their fair value measurements.”

Rash observers may scoff at consequences for companies that will generate revenues as before and assume similar risks. To them, reshuffling ledgers evokes a shift from FIFO to LIFO accounting in the late 1970s as inflation climbed toward 20 percent. In those remote days managers fretted that higher costs of goods sold under LIFO would depress earnings; keener observers saw a more meaningful impact — lower taxes.

Do not assume that fair value changes are merely cosmetic, the Credit Suisse authors warn. The impact is real and far reaching.

“For those companies where a significant portion of the balance sheet is at fair value, you may need to rethink how you analyze and value them,” the authors warn. “Especially if changes in fair value are running through earnings, as that would make forecasting earnings extremely difficult (unless you had a crystal ball) and if a large chunk of earnings are marked to market, an earnings based valuation (P/E multiple) could be a waste of time. Why would you bother putting a multiple on mark-to-market earnings (it’s not sustainable) when you already know what the assets and liabilities are worth.”

At least one unintended consequence has triggered calls to suspend mark-to-market until volatile markets grow steadier and write-offs abate. As market weakness or rising interest rates lower the cost to redeem debt, companies can claim the resulting adjustment as added income. That phenomenon sparked heated debate during the first of two panels at yesterday’s SEC roundtable on fair value. But fair value proponents note that declining asset values should partly offset phantom gains, and in any case as a company regains its footing the valuations will correct themselves.