The Land Mines in Market-to-Market Accounting Standards

0:00It is, I think, unusual that accounting would be a subject of debate in public policy in this country today. But it is, and there's probably no group of people less ill-disposed to the give and take in conflict of public policy than the accounting community. And I say that with great affection for my accounting colleagues. But I also say that if they had been running the country in 1776, we would still be working for the king, truly. They are mostly conflict-averse, gentle people, and public policy is anything but conflict-averse or gentle. I want to talk to you, and I hope I can do this without anesthetizing anyone, about landmines and market-to-market accounting standards.

0:54H.R. 1349 Introduced the U.S. House of Representatives last week by a left-leaning Democrat and a right-leaning Republican proposing to establish something called the Federal Accounting Oversight Board, FAOB, five-member board, Chair of the SEC, Federal Reserve Chair, FDIC Chair, Secretary and Treasury, and a chair of something called the PCAOB, also known in my line of work as Peek-a-Boo. Peek-a-Boo. And this is the Public Company Accounting Oversight Board, which was created with the Sarbanes-Oxley legislation of 2002. This is for public companies.

1:46NASB Chairman Bob Hertz, a nice if somewhat misguided man in my opinion, testified yesterday in front of the capital market subcommittee, House Financial Services Committee, and I think he developed a rather keen empathy for General Custer while he was there. I am reminded of what a friend of mine said one time after he came out of defending his dissertation. I said, how did it go? Well, I feel as if I'm a man who's been in a rake fight without a rake. I think Bob Herz got some empathy for that yesterday. Herz agreed that FASB would issue, quote, guidance. Also, probably not too far from the financial equivalent of commandments, if you will, but they call it guidance, will be coming down from the mount within three weeks.

2:39For FASB, this is lightning speed. This is lightning. It's unheard of. I'm sure everybody in Norwalk, Connecticut, where FASB's headquarter was in cardiac arrest yesterday when Chairman Hertz made that comment. But they're going to issue some guidance about evaluation situations involving distressed markets and illiquid markets, which the farther you go down the balance sheet of a company, the riskier things get, whether you're on the asset side or liability side. The farther down you go, you start with current assets, cash, accounts receivable, inventory, you're getting riskier and riskier, then you get down to fixed assets. Then below fixed assets, since 2001, we've had a growing category called intangible assets. Okay? And those are even riskier. Think trying to sell your, trying to sell the non-compete agreement which is on your balance sheet. You can imagine and there's a huge market for that, and of course the riskiest asset of all is goodwill.

3:45When you go down the right side of the balance sheet, liabilities, long-term debt, things get riskier, you get into shareholder equity, the riskiest component of that of all is common equity. Those are the people that get wiped out when banks go into, or when banks, sorry, when and companies go into restructuring or liquidation. Problems, problems, problems with market to market. We have problems with the FASB's understanding or lack thereof of Austrian economics. We have problems with other valuation related FASB pronouncements and we have problems, especially these days, with sign-offs by auditors. Now have we got any auditors in the house here?

4:31Okay, I don't want to hurt any auditors' feelings. But let me try to simplify the comparison, the contrast, if you will, between what I do for a living and what those nice people do for a living. Valuation, which is what I do, is prospective. It is forward-looking. is the seers, if you will, perceive present value of future benefits, however defined. Auditors look backwards. If they wanted to deal with the ambiguity and uncertainty of the future, they would have never become auditors. Okay? And so when I tried to explain valuation Issues to an auditor, I feel rather like a guy trying to teach a fish to ride a bicycle.

5:26It is tough duty, folks. The problem is, my client's got to pay me to educate the auditor. And I've seen situations where the client ended up paying the auditor for their time related to my work that they couldn't understand. They paid the auditor more than they paid me to do the basic evaluation. Now if I didn't have a clue about what I was doing, that might be one thing, but there are market tests for that kind of thing, every place on the Capitol Hill it seems like. The problem really began, I say began, it went into overdrive if you will, in September In December of 2006, when FASB issued something called FAS, SFAS, which stands for Statement on Financial Accounting Standards, 157, which was entitled Fair Value Measurements. And it had two fatal errors that, in this crisis we've been dealing with for over a year now, have had the effect of essentially pouring kerosene on the avoidable bonfire that's clobbering most of us.

6:401957 created what's called a new standard of value. I'll talk about that momentarily, but it puts downward pressure on asset values in falling markets and upward pressure on them in rising markets. That's the first problem. The second problem is FASB used the bad old paradigm and it totally ignored individual subjectivity of value, totally ignored that. Let's talk about standard value issues. Standard value answers the question, value to whom? And my favorite example of this is I live out in the Virginia countryside, we call it God's country. And let's say I were a wealthy man, which I'm not, and I own two pieces There's land out there, five acres each, let's say, separated by a strip of land about fifty feet wide that I do not own, the owner of whom does not like me, so the only way I can get from parcel A to parcel B is I can go down to the end and outflank them, or if I'm in better physical shape than I'm in, I can pole vault.

7:51That's about the only way I can do it, assuming he's not out there claiming airspace being and his two. So that particular strip of land would probably have no value to anybody in this room except me. It's probably worth a bucket of money to me. Subjectivity of value. Value to whom? FASB overturned one hundred years of practice when they established something called fair value and it overturned something called fair market value. Lest you think that that that is a distinction without a difference, let me assure you it is not, and I will make that case momentarily. Why did FASB do this? Well, in a word, Enron. SEC told them, don't you ever, don't you ever create any county standards that allow an Enron to happen ever again. Now, I would argue in the current market that Enron is chump change. Not to those poor Fair market value is not the same as fair value, believe me. There are two definitions, here's fair market value, kind of a classic definition, the price at which a property would change hands between a willing buyer, a willing seller, when the seller, when the seller

9:23and the buyer neither is under any compulsion to buy or sell, both parties having reasonable knowledge of relevant facts. Court decisions frequently state in addition that the hypothetical buyer and seller are assumed to be able as well as willing to trade and to be well informed about the property concerning the market for such property. It's fair market value. IRS Here's fair value. The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.

10:15Now, what we have done here, and you might not have noticed this, okay, there we go. This is, in essence, an entry price. An entry price. What someone paid for something, assuming an orange link transaction. This is an exit price. This is an exit price of something that hasn't happened and may never happen. It is hypothetical to the max as written.

11:02Exit Pricing for MTM, not Mary Tyler Moore, mark to market. To define exit pricing, as I said a moment ago, FASB created this construct called market participants. That's a reference to paragraphs 10 and 11 of FAS 157, synopsis of those paragraphs. The market for given asset or liability creates a consensus about value. are not entity specific. In other words, what I paid for something might not be what it shows up as on my personal balance sheet. I am not making this up.

11:47Let me horrify you a couple of steps further here. We've already talked about that. We We talked about that, we talked about that. Incent pricing is really not a problem so long as markets don't seize up and so long as we're talking about financial instruments when markets don't seize up. In other words, so long as we're talking about stuff that's in the current asset section of the balance sheet in ordinary markets, fair value is not a problem. But once you get out of the current section of the balance sheet, and you go farther down, as I said, those assets get riskier, they become more entity specific, and the idea of market participants becomes a mirage.

12:43There we go, widget machines, non-compete, customer relationships are on a lot of companies' Again, what a company paid for something is not necessarily that something's fair value. There is a hierarchy that FASB also defined in Paragraphs 22-31 of FAS 157. It says companies These must use quoted market prices, must use quoted market prices. Classic example, Merrill Lynch, last May, sold 30 something billion dollars of mortgages at 22 cents on the dollar.

13:30That laid down a pricing benchmark that everybody had to follow, who was marking mortgages to Market. Okay? 22 cents on the dollar. Even if they're not, even if those prices are not available, the hierarchy requires exit pricing someone else's perspective. Now, when we get to the subjectivity of value, I might buy a set of screwy looking assets because I have a perception of how to configure them in a way that creates and an inimitable money machine. I'm not the only person in the history of the world that's thought of that. But FASB requires me, when I value that configuration of assets, to value it on the basis of what a bunch of people that they can't name and I can't name might pay for it, assuming these people had a clue about what my idea was, which they don't.

14:35Any way you slice it in a declining market, exit pricing is liquidation pricing. Exit pricing is liquidation pricing. Most value is done on what's called a going concern basis. That is the assumption that the entity will continue to operate. When you assume liquidation, values fall significantly. And even within liquidation, there's voluntary orderly liquidation if you will which can dribble out over a period of time and then there's that crash kind of liquidation where we got to sell this stuff by the end of the day tomorrow again prices fall further let me give you my favorite example and this is ladies and gentlemen fasten your Let's assume we have a Picasso painting that's going to be auctioned off at Sotheby's and every prominent Picasso collector in the world is either there or is represented. Bidding opens up 5 million, 10 million, 15 million, 20 million, 25 million, 27 million, the crowd is starting to thin out. 29. Sold at 30 million. Okay? 30 million. Let's assume a gallery bought

15:57this for 30 million dollars. And the fair value is, anybody know? Hmm? Anybody? 29 million! And the reason it's 29 million is that 30 million is entity specific to the gallery, and 29 million is when there were at least two parties in the market. I'm not kidding you, ladies and gentlemen. I don't know what they're smoking in Norwalk, but I mean to tell you, this is ugly. So if Gallery Deluxe paid $30 million for this thing, and I come in the next day to test their long-live assets for impairment, they have an immediate $1 million write-down on their balance sheet.

16:56That $1 million goes straight through their profit and loss statement. You didn't think accounting could be this exciting, did you? You thought accounting was objective. You thought accounting was about numbers. How complicated can this be? Right? 29 million. As I said, 30 million is entity-specific, two buyers. 29 million is a fair value. Got the million-dollar impairment charge. And again, I'm not only not making this up, I couldn't make this up. And I have a pretty fertile imagination. Mid-2001, and will on the balance sheet was no longer written off on a periodic basis for financial reporting purposes. It became subject to annual impairment testing, annual impairment testing, at least annually. Stock prices are down big time, just year over year, 1231, 2007, 1231, 2008, anywhere from 37.5% to almost 41%. You think there aren't going to be big impairment Hits coming up, you haven't seen anything yet. You think first quarter of 2009 is not going to be a bloodbath because the first quarter of 2009 is when non-financial companies

18:25have to start measuring all of their assets at fair value and not just their financial assets. It is going to be a bloodbath. Now, I don't predict markets, so don't ask me what I think is going to happen because I have no idea. I do know this. There are four rules of predicting. First is predicting can be imprecise, especially if it's about the future. The second is if you must predict, predict often. Predict often. The third is give them Give them a date or give them a number, but never give them both.

19:12And number four is, in the unlikely event that you are ever right on any prediction, never let them forget it. So let's see here. An impairment charge, because it goes through the profit and loss statement, it's going should reduce that income, should reduce price-earnings ratio or whatever else, should affect a stock price which then might trigger another impairment charge which might then trigger further fall in the stock price and you see where this death spiral goes. We don't know where it ends. There is more. If you thought $30 million and $29 million City Bank, much in the news these days, took a hit in its credit rating by the ratings agencies in the third quarter of 2008. In its 10Q for Q3 2008, they show, right out there in front of everybody, that because of the downgrade in their credit rating they reduced their Our long-term debt by one and a half billion dollars, okay?

20:41For the accountants in the room, that means they debited something, okay? So it means there's got to be an offsetting credit somewhere. Where did that offsetting credit go? A gusher on the P&L, billion and a half plus on the P&L. So let me get this straight. We downgraded my credit rating and my net income goes up. Have I got this right? You don't have to be an accountant to say this is crazy. Now in fairness, in fairness, in fairness, the city didn't originate this. The first time this was actually done was in Q3 2007 with the lately un lamented Bear Stearns.

21:32They ran 225 million, same thing, credit rating downgrade, 225 million right down, 225 million gusher on the P&L, kept them from showing their first loss in all the years they've been in business. There's a transcript of the earnings call on the internet, if you want it from me, W. I'll send you a link, they talked about it. The FASB was horrified when this happened. Oh, we didn't think of that? But the fact is there's no other place for it to go. If you lend me $10,000 and I'm only going to repay you $6,000, then I am $4,000 to the good, at least in theory.

22:21And that's the rationale here. This phrase moral hazard starts to filter through your mind. You know, you can make a pretty good case, well gee whiz, maybe it's in our best interest to have credit downgrades. Particularly if our incentive compensation is tied to the P&L. Then there's FAS 141R, which is a revision of how to account for acquisitions, transaction-related expenses, expenses people like me that advise at M&A, do valuations, etc., are no longer part of the deal price. Market participants, you go to sell that acquisition the next day, They're not going to pay you for Miller's expenses. All those high-priced lawyers. No, no, no, no, no.

23:22You cannot put that into the value of that acquisition. And you say, but wait a minute, conventional accounting, do I buy a widget machine? It gets shipped. We've got to pay some money to have it installed and tested and get the software running. That's all part of the install cost of the widget machine, right? Right! Well then, does market participants If you've not had enough, you may also have now a requirement to book at the time of closing what are called contingent liabilities. If you work in the middle market where I spend most of my time, you frequently bridge the gap between a seller who thinks her company is worth a bazillion dollars and a buyer who who thinks the company is worth a bazillion less, half a bazillion, okay, so you have this pricing gap, and that's usually bridged by something called an earn-out, and in essence the deal documents say, if this thing performs as the seller says it will over this period

24:34of time, then the seller will get some sum of money at some date certain, okay, no problem. Historically, that has never been booked until it happened, because you didn't know it was going to happen until it did. Nah, nah, Fasby says, no, no, no, no, no, that's not good enough. You have to book that at the time of closing. Now, let's go back to our debt example. What are the incentives that Fasby's creating here? Let's have a real high contingent liability, so that if it turns out to be lower, we'll get another juicer going through our P&L. This is just Human Nature 101, which believe me is alien in Norwalk, Connecticut. I don't disparage the population there, just the population 7 Merit, which is their address. You want that contingent liability to be too high or too low? Well, of course, the higher the contingent liability is, the lower your equity is going to be, which reduces the likelihood you'll have an impairment. So you get a two-fer here. You get a two-fer? Ah, human nature. Okay.

25:55Contingent liability, exhibit two. Assume your small publicly held company at the evaluation date is party to a lawsuit, exactly one lawsuit, only one lawsuit. Council says, well, you can prevail, but that's going to cost you a lot more than settling, even though you're and you're not guilty of anything. Pragmatic business people in that case say, as long as it doesn't set too ugly a precedent, we'll bite the bullet, save some money and pay. But you have to disclose that in your 10K filing with the SEC and how do you like to be counsel on the other side of this deal? Counsel your competitors, everybody, monitor those SEC filings.

26:44and the details of this contingent liability would have to be disclosed, which makes legal strategy dicey to say the least. Then we have signing, sign-off by outside auditors, again, got to be accepted. They can't do valuations because then they'd be auditing their own work. So there's a conflict of interest, basic difference between valuation and auditing I told you about earlier to make it there is no consistency among audit firms incidentally and how they deal with valuation issues even among the four biggest audit firms some people call the big four I call them the four and something else that rhymes with four but those big four firms do have an advantage they do have in-house professionals on evaluation side reasonably sophisticated people but the further down that CPA firm food chain you go So, the less likely you are, A, to find auditors who even know, gee, I think I'd better talk to our valuation people, or B, firms that even have in-house valuation people.

27:54There's that having to pay folks like me to tutor their backward-looking auditors about forward-looking valuation issues, and there's that situation I described to you earlier. Summing up, where are we? Those who have never done a purchase price allocation or impairment analysis, or fair value accounting in general. That includes every one of the board members at the Financial Accounting Standards Board and every permanent staff member. There is nobody, nobody in a population of over 200 who has ever spent one single day doing what I do for a living. That one. I said to Bob Hurst last September, face to face, I said, Bob, why don't you all have a serious credential evaluation person on your board?

28:45He said, ah, they'd have to know the accounting issues. I said, Bob, why doesn't that saw cut the other direction? He kind of gave me a thousand mile stare in a four-foot room. And I said, you know, Bob, I'm developing some empathy for what I think the cardiologist This would feel like if proctologists started telling them how to do heart surgeries. Numbers are precise. The auditors audited GM, didn't they? Christopher Cox and certain groups with far too much time on their hands, in particular my colleagues at CFA Institute, of which I'm a proud member, this first policy issue that When you tell these people, when you tell FASB, when you tell Kurt Schacht, that two If two conscientious and competent appraisers might come up with estimated values that are 10-15% apart, they'll just tell you that's impossible.

30:05No, it's not. Not when you're talking about illiquid assets. It's not impossible at all. And two very bright, very experienced, very ethical valuation people can come up with two very different answers. Do you think a 10 or 15 percent swing in the company's balance sheet might make a difference? We can't value long life assets any more accurately than 10 or 15 percent, we just can't. Think non-contractual customer relationships, that's my kind of poster child.

30:54You want to value something, value that sometime. You'll find out what burn incense and face mecha is really all about. Okay? We need common sense, not theory, but there's nobody there who's done this stuff, so all they know is theory, and the only winners in this sort of tale are the auditors and people like me. American shareholders of public interest is being very ill-served by this. And you say, well gee whiz, Miller, if you're making so Why are you out here complaining about this? You'd be saying the same thing my wife asks me. Why are you complaining about this, dear? Seriously. If you do right, buy investors. Everything else will kind of go where it needs to go.

31:43It'll go where it needs to go. Just do right. It's not complicated. I don't get preachy about it. There are other flaws in mark-to-market standards rooted in strategic management, my home field, organization theory, evolutionary economics, industrial organization, in addition to Austrian economics, and I'm writing a book now marrying these five disciplines. They call into question the very existence of market participants once you get into Long Live the S.F. Value is subjective, i.e. company or entity-specific. And it's the entity-specific stuff that drove SEC to mandate FASB no more in runs.

32:30I hope the SEC is happy.

32:38If you want a PDF of an article I've written or any of that stuff, Send me an email, wmiller at beckmiller.com. I'll be glad to take any questions. Any, are you sure you said that Miller? Kind of, kind of thing. Please. No, no, no, no, no. We're going to take questions at the end. At the end. Excuse me. Yep. Questions at the end. Excuse me. Thank you.