Oracle of NY

The History of Mark-To-Market Accounting (cont.)

The use of fair value measurement expanded significantly in 1975, with the issuance of authoritative accounting literature that mandated its use in certain circumstances due to concerns about the appropriate measurement attribute for equity securities.

Prior to 1975, there was a lack of consistency in accounting literature, which resulted in diversity in accounting practice, specifically with respect to marketable securities. Accounting practices included carrying such securities at cost, at market, and, in some cases, a combination of both measurements for different classes of securities.

During 1973 and 1974, there were substantial declines in the market values of many securities. These declines, in many cases, were not reflected in financial reports. When the market recovered in 1975, the accounting guidance was unclear on whether securities previously written down could be written up to previous carrying amounts. As a result of these issues, the FASB issued SFAS No. 12, Accounting for Certain Marketable Securities, in December 1975, which required that all marketable equity securities be recorded at the lower-of-cost-or-fair-value. Debt securities continued to be accounted for at amortized cost.

The History of Mark-To-Market Accounting (cont.)

In the aftermath of the Great Depression, there was a general move toward more “conservative” accounting. This included a move away from the use of “current values” or “appraised values” for long-lived assets such as fixed assets and intangibles.

This move away from “current value” accounting and towards the use of historic cost accounting for long-lived assets was strongly supported by Robert E. Healy, the first Chief Accountant of the SEC. Healy had participated in the Federal Trade Commission (“FTC”) investigation of business practices that preceded the formation of the SEC. This investigation uncovered widespread use of asset writeups which the FTC viewed as arbitrary. Commenting on the findings of this investigation, Healy is quoted as observing that “you can capitalize in some states practically everything except the furnace ashes in the basement.”

During Healy’s tenure, the newly-formed SEC strongly endorsed historic cost accounting for long-lived assets and moved to curtail the use of “appraised values” through the registration process. By 1940, the practice of the upward revaluation of fixed assets – a practice that had been commonplace in the late 1920s – was virtually extinct from financial reporting in the U.S.

The History of Mark-To-Market Accounting

Some history from the SEC study:

Prior to the development of mandatory accounting standards following the Great Depression, companies had significant latitude in selecting their own accounting practices and policies. There is evidence that the use of “current values” or “appraised values” for assets, and the recording of upward asset revaluations, were common in the early-twentieth century in the period prior to the Depression. During this period, balance sheets often included upward revaluations of long-term assets such as property, plant, equipment, and intangible assets.

For example, a survey of 208 large industrial firms between 1925 and 1934 revealed that 75% of the sample firms recorded upward or downward asset revaluations during this period, including 70 write-ups of property, plant, and equipment, seven write-ups of intangibles, and 43 write-ups of investments.

Further, prior to 1938, banking organizations were required for supervisory purposes to use market value accounting for their investment securities portfolios. Serious concerns on the part of the U.S. Treasury and the bank regulators over how this affected the banks’ financial performance and investment decisions led the agencies to abandon in that year the use of this accounting concept for supervisory purposes.

Conclusions from the SEC Study on Market-To-Market Accounting

The Staff observed that fair value measurements were used to measure a minority of the assets (45%) and liabilities (15%) included in financial institutions’ balance sheets. The percentage of assets for which changes in fair value affected income was significantly less (25%), reflecting the mark-to-market requirements for trading and derivative investments. However, for those same financial institutions, the Staff observed that fair value measurements did significantly affect financial institutions’ reported income.

The Staff observes that fair value accounting did not appear to play a meaningful role in bank failures occurring during 2008. Rather, bank failures in the U.S. appeared to be the result of growing probable credit losses, concerns about asset quality, and, in certain cases, eroding lender and investor confidence. For the failed banks that did recognize sizable fair value losses, it does not appear that the reporting of these losses was the reason the bank failed.

The Staff’s research on this issue reflects that, based on these sources, investors generally support measurements at fair value as providing the most transparent financial reporting of an investment, thereby facilitating better investment decision-making and more efficient capital allocation amongst firms. While investors generally expressed support for existing fair value requirements, many also indicated the need for improvements to the application of existing standards. Improvements to the impairment requirements, application in practice of SFAS No. 157 (particularly in times of financial stress), fair value measurement of liabilities, and improvements to the related presentation and disclosure requirements of fair value measures were cited as areas warranting improvement.

Context for the SEC Study on Market-To-Market Accounting

The SEC's study gives some background concerning what lead to the study:

Over the last 12 to 18 months, the world economy has experienced economic conditions that have affected financial and non-financial institutions. What at one time some viewed as an isolated crisis in the subprime mortgage sector has spread to the global economy as a whole. Factors that have been cited as causing or contributing to the current economic crisis include, among others, low interest rates, rapid housing appreciation, alternative mortgage products, relaxed underwriting standards, increased leverage, innovative new investments that were institutions are experiencing the brunt of increasing mortgage defaults, housing foreclosures, bank failures, and tighter credit, other industries are experiencing losses, liquidity issues, rapid decreases in market capitalization, layoffs, and lower consumer confidence – all underscored by the National Bureau of Economic Research’s recent announcement that the U.S. has been in a recession since December 2007, which is expected to “likely be the longest, and possibly one of the deepest, since World War II.”
 
While analysis of the causes of this crisis is still underway, some believe that fair value accounting standards have contributed to or exacerbated this crisis, arguing that use of fair value accounting, particularly when markets are illiquid, has resulted in the valuing of assets well below their “true economic value.” Opponents of fair value accounting also argue that these write-downs have caused a downward spiral, as they have triggered margin and regulatory capital calls, “have forced rapid asset liquidation, exacerbating the loss of value, diminished counterparty confidence, and constrained liquidity.” Proponents counter that fair value accounting provides useful information to investors and its suspension would increase market uncertainty and decrease transparency. It is in this context that the Staff has performed this study of mark-to-market accounting to fulfill the Congressional mandate.

SEC Recommendations on Mark-To-Market Accounting #3

While the Staff does not recommend a suspension of existing fair value standards, additional measures should be taken to improve the application and practice related to existing fair value requirements (particularly as they relate to both Level 2 and Level 3 estimates).

• Fair value requirements should be improved through development of application and best practices guidance for determining fair value in illiquid or inactive markets. This includes consideration of additional guidance regarding:
  - How to determine when markets become inactive
  - How to determine if a transaction or group of transactions is forced or distressed
  - How and when illiquidity should be considered in the valuation of an asset or liability, including whether additional disclosure is warranted
  - How the impact of a change in credit risk on the value of an asset or liability should be estimated
  - When observable market information should be supplemented with and / or reliance placed on unobservable information in the form of management estimates 
  - How to confirm that assumptions utilized are those that would be used by market participants and not just by a specific entity

• Existing disclosure and presentation requirements related to the effect of fair value in the financial statements should be enhanced.

• FASB [Financial Accounting Standards Board] should assess whether the incorporation of changes in credit risk in the measurement of liabilities provides useful information to investors, including whether sufficient transparency is provided.

• Educational efforts to reinforce the need for management judgment in the determination of fair value estimates are needed.

• FASB should consider implementing changes to its Valuation Resource Group.

A Truly Historic Day

Highlights of President Obama's inaugural speech:

For everywhere we look, there is work to be done. The state of the economy calls for action, bold and swift, and we will act — not only to create new jobs, but to lay a new foundation for growth. We will build the roads and bridges, the electric grids and digital lines that feed our commerce and bind us together. We will restore science to its rightful place, and wield technology's wonders to raise health care's quality and lower its cost. We will harness the sun and the winds and the soil to fuel our cars and run our factories. And we will transform our schools and colleges and universities to meet the demands of a new age. All this we can do. All this we will do.

The question we ask today is not whether our government is too big or too small, but whether it works — whether it helps families find jobs at a decent wage, care they can afford, a retirement that is dignified. Where the answer is yes, we intend to move forward. Where the answer is no, programs will end. And those of us who manage the public's dollars will be held to account — to spend wisely, reform bad habits, and do our business in the light of day — because only then can we restore the vital trust between a people and their government.

It is the kindness to take in a stranger when the levees break, the selflessness of workers who would rather cut their hours than see a friend lose their job which sees us through our darkest hours.

Our challenges may be new. The instruments with which we meet them may be new. But those values upon which our success depends — honesty and hard work, courage and fair play, tolerance and curiosity, loyalty and patriotism — these things are old. These things are true. They have been the quiet force of progress throughout our history. What is demanded then is a return to these truths. What is required of us now is a new era of responsibility — a recognition, on the part of every American, that we have duties to ourselves, our nation, and the world, duties that we do not grudgingly accept but rather seize gladly, firm in the knowledge that there is nothing so satisfying to the spirit, so defining of our character, than giving our all to a difficult task.

 

SEC Recommendations on Mark-To-Market Accounting #2

Existing fair value and mark-to-market requirements should not be suspended.

Observations:

- Fair value and mark-to-market accounting has been in place for years and abruptly removing it would erode investor confidence in financial statements.

- Fair value and mark-to-market accounting do not appear to be the “cause” of bank and other financial institution failures.

- Mark-to-market accounting is generally limited to investments held for trading purposes and for certain derivative instruments; for many financial institutions, these represent a minority of their total investment portfolio.

SEC Recommendations on Mark-To-Market Accounting #1

SFAS No. 157 [the standard that defines fair value accounting] should be improved, but not suspended.

Observations:

- The guidance in SFAS No. 157 does not determine when fair value should be applied. SFAS No. 157 only provides a common definition of fair value and a common framework for its application.

- Suspending SFAS No. 157 itself would only revert practice to inconsistent and sometimes conflicting guidance on fair value measurements.

- Other recommendations address necessary improvements to existing standards.

SEC Study on Mark-To-Market Accounting (cont.)

The study was conducted, because some people blamed "mark-to-market" or "fair value" accounting for causing or at least contributing in a significant way to the financial crisis:

The events leading up to the Congressional call for this study illustrated the need for identifying and understanding the linkages that exist between fair value accounting standards and the usefulness of information provided by financial institutions.

In the months preceding passage of the Act, some asserted that fair value accounting, along with the accompanying guidance on measuring fair value under SFAS No. 157, contributed to instability in our financial markets.

According to these critics, fair value accounting did so by requiring what some believed were potentially inappropriate write-downs in the value of investments held by financial institutions, most notably due to concerns that such write-downs were the result of inactive, illiquid, or irrational markets that resulted in values that did not reflect the underlying economics of the securities.

These voices pointed out the correlation between U.S. GAAP reporting and the regulatory capital requirements of financial institutions, highlighting that this correlation could lead to the failure of long-standing financial institutions if sufficient additional capital is unavailable to offset investment write-downs.

Further, they believed the need to raise additional capital, the effect of failures, and the reporting of large write-downs would have broader negative impact on markets and prices, leading to further write-downs and financial instability.

SEC Study on Mark-To-Market Accounting

I finally got around to reading the hefty government-mandated report (part of the Emergency Economic Stabilization Act of 2008) recently released by the SEC on mark-to-market accounting, and I will point out the highlights:

Although not mandated for study by the Act, the Staff believes that it is important to recognize what many believe to be the larger problem in the financial crisis that led to the financial distress at financial institutions other than banks, including The Bear Stearns Companies, Inc. (“Bear Stearns”), Lehman Brothers Holdings Inc. (“Lehman”), and Merrill Lynch & Co., Inc. (“Merrill Lynch”).

Rather than a crisis precipitated by fair value accounting, the crisis was a “run on the bank” at certain institutions, manifesting itself in counterparties reducing or eliminating the various credit and other risk exposures they had to each firm. This was, in part, the result of the massive de-leveraging of balance sheets by market participants and reduced appetite for risk as margin calls increased, putting enormous pressure on asset prices and creating a “self-reinforcing downward spiral of higher haircuts, forced sales, lower prices, higher volatility, and still lower prices.” The trust and confidence that counterparties require in one another in order to lend, trade, or engage in similar risk-based transactions evaporated to varying degrees for each firm very quickly.

What would have been more than sufficient in previous stressful periods was insufficient in more extreme times.

Discounted Gifting Opportunities

There is an immediate opportunity for people considering gifting closely-held operating companies and family limited partnerships:

“Current Global Economic and Credit Crisis”

• Can support lower value conclusions in front of the IRS



• Operating businesses, marketable securities, and real estate worth less based on current business climate (less demand, no credit to fund business operations and acquisitions)



• Get closely-held business and real estate appraisals done sooner rather than later to support reduced values



• Can support greater discounts for lack of control and lack of marketability for minority (non-controlling) interests
  
  – Credit crunch, difficult for consumers and businesses to get loans, pay bills
  
  – Lack of affordable consumer credit reduces consumer spending and, as a result, weakens our economy
  
  – Public marketplace is disruptive, reflected in reduced pricing (lower values) for some of America’s strongest companies
  
  – Significant job losses and unemployment at high levels
  
  – If public companies are severely impacted, what about closely-held businesses?

Factors to Consider when Valuing a Business (cont.)

• Review trading multiples for comparable publicly traded companies in similar businesses
  – Market evidence to support value conclusion



• Review sale transaction multiples for comparable companies (public or private) in similar businesses
  – Market evidence to support value conclusion



• Managements track record and its ability to achieve its objectives



• Key employees, business referral relationships, customer dependencies, access to capital to support and grow business



• Applicable discounts for lack of control and marketability

Factors to Consider when Valuing a Business

• The nature of the company’s business and its history (milestones, profitability, growth profile)
  
  
• The outlook for the economy, subject industry, and competitive landscape (impacts demand)
  
  
• The financial condition of the company (use of debt)
  
  
• Analyze the past and future earnings capacity of the company
  – Investing is forward looking, use history to help understand the future
  
  
• Prior transactions involving the company’s stock (indication of value)
  
  
• The ability of the company to distribute earnings (dividends)

Lack of Marketability Discount

The size of the discount applied to a specific interest is dependent on many factors:

• Dividend capacity
  - Has, can, will the investment/company pay dividends?



• Probable holding period
  - How long is the investment term, 3 to 5 years?
  - When can it be sold
  - Prospects for liquidity



• Degree of control in the block of stock
  - Control interest is more marketable than minority interest



• Restrictions on transferability (right of first refusal)



• Company’s stock redemption policy 

In short, how and when can I turn my investment into cash?