Wednesday, May 14, 2008

CPA Debate

The American Institute of Certified Public Accountants (AICPA) publishes a monthly magazine titled the Journal of Accountancy. In their May 2008 issue, they have a point-counterpoint (not as wild as the old Saturday Night Live skits with "Jane, you ignorant sl*t") on the topic of "fair value" for accounting.

I posted indirectly on the topic of fair value in this post when I noted that quarterly reporting, which is frequently charged with contributing to short-term thinking in the markets, had salutary effects in that CEO's were forced to publish results frequently which led to the ousters of many CEO's in the financial industry who were responsible for disastrous write-offs.

WHAT IS FAIR VALUE?

In a simplified version, the topic of "fair value" relates to whether or not write-downs should be taken on assets on the balance sheet (which reduces profits on the income statement) based upon reductions in market values, even if the assets haven't been sold. For example, if a company has a bunch of loans on their books for $10B, and based on recent downturns in the market and sales of similar assets to third parties, the CURRENT value is $8B, then that company would reduce the value of the asset by $2B on the balance sheet and show a $2B loss on their income statement.

The controversy comes from a few elements; for one, the company hasn't sold the assets yet nor has it incurred the loss (in cash). In other words, if the company holds the assets (the loans) until maturity, and the interest all turns out to be paid and the principal too, then there won't be a loss at all. However, if the company had to sell the asset today, then it would likely incur this loss.

The second element of the controversy is that when the markets "seize up", there aren't reliable benchmarks to use for comparisons. For example, if you paid $300,000 for your house, and there were only a couple of sales (and the houses weren't very close in characteristics to your house, maybe a few towns away) because no one was desperate enough to sell into this market (wanted to wait it out), and these sales were for $200,000, did you just incur a $100,000 loss? You might say no, because the market isn't working right now (the market comps aren't accurate) and anyways you aren't selling in the near term. On the other hand, if you had a no-down loan, and owed $300,000 on the house, and needed to sell right now, then you would really feel the force of the loan. Wikipedia has a decent description of "fair value" at this link.

The third element of controversy is that accounting prefers known values, so accountants like to stick with "historical cost" whenever possible. In this example, if you pay $300,000 for the house, the house remains at a value of $300,000 on your books whether or not it increases or decreases in value, until you finally make the sale. The "historical cost" bias is incredibly strong in accounting, especially for those in the "old school".

THE DEBATE - NOT GETTING IT

I am not an expert on fair value but I was struck by whom the AICPA selected to represent the "historical cost" point of view; he was the former auditor general of GM. I found supreme irony in this selection, which I will try to explain below.

At the heart of the debate on "Fair Value" is the debate as to whether or not the income statement approach or the balance sheet approach is superior. The "pro" fair value camp says that if your assets (or liabilities) change in value, you need to recognize this and run it through the income statement. The "anti" camp says in fact that the income statement is superior; if you earn $50k / year and your house declines in value by $20k (with no sale), then your income is $50k, not $50k - $20k or $30k (this is obviously a simplified and abstract example, for discussion purposes only, but is instructive).

Let's talk about what brought GM to its' knees (among other things) - it was the BALANCE SHEET. GM raised billions of dollars from debt and equity investors to build plants, and GM ran these plants at a gain or loss. But the real issue was - what was the VALUE of these investments? What is the value of a plant that builds cars no one wants? Very low - GM was a monstrous destroyer of balance sheet value over the years; they raised money, invested it, and then it was gone. What are the assets of GM worth? Not much.

The other side of their balance sheet, their liabilities, grew every year. The true cost of their unionized work force wasn't just felt every year, as their labor expenses were matched against the revenues from building cars, but it was the CUMULATIVE LIABILITY of all these retirees future pension costs and medical benefit costs, that would be incurred in the future. These liabilities strangled the enterprise, until recently they created a VEBA and transferred these liabilities to the unions, at the cost of billions of dollars.

The "anti" fair value tag line was "The Need for Reliability in Accounting" and every year, dutifully, he worked with a company that created an income statement showing that they were earning or losing a few millions or even billions. But this "reliable" statement, which helped them to raise billions in debt and equity from investors, was ultimately not an accurate guide for investors, because these balance sheet issues wiped out virtually all the value of the enterprise.

This isn't to say that GM is doomed; these acts (such as the VEBA) and their grappling with unions (witness the recent strike) as they whittle away their unionized staff in the USA (and invest overseas), means that they are finally tackling their issues head on. Their balance sheet issues, caused by liabilities out into the future that swamp their earnings today, and not offset (for the most part) by write-ups of asset values.

MORE IRONY

One of the assets that GM had to sell off (to raise money for the VEBA, to fix their liabilities) was GMAC (their financing arm). Now many of the investors who bought into this enterprise are having to write off a portion of their investment since fair value is the law of the land. In today's WSJ an article is titled "Valuations Still Part Art" which describes how various investors are struggling to determine how much of the value of this asset to write off - per the article:

"If you invested $100 million in GMAC LLC in 2006, what is it worth today? (A) $90 million; (B) $80 million; (C) $75 million; (D) all of the above?

The answer is D -- the loss could be any of the above, depending on how the investment firm that bought the securities is valuing them."

A different article in today's WSJ is titled "GM May Look To Raise Additional Cash" due to the fact that they are draining cash due to the strike, high gas prices, and a decline in sales - and they are hoping that more investors will give them cash to plug their losses, ignorant of GM's history of value destruction. More than likely, they will raise this money, from "reliable" investors... who can't understand history.

Cross Posted at Chicago Boyz

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