Abolish Fair-Value Accounting

In our post of October 9, 2008, “What’s Fair About Fair-Value Accounting?” we commented on the process of marketing-to-market when there is no market, that is, when there is a dearth of willing buyers and sellers and essentially no fair price to clear the market. As we noted, U.S. banks are required to mark-to-market most financial assets other than loans. Our recommendation was that the SEC should instruct FASB to abolish fair-value accounting once and for all.

Well, somebody was listening, at least across the pond, as the Wall Street Journal reports today (“EU Banks Get Leeway on Making Write-Downs,” October 20, 2008, page C1, C2). New accounting riles in Europe would allow banks to reclassify some assets as investments, allowing more flexibility in deciding what they are worth. The risk of course is that banks will cook the books, possibly leading to abuses in the reporting of the actual value of certain assets and impacting reported earnings.

At the risk of being repetitious, banks (whether U.S. or elsewhere) should follow the following procedure:

1. Model the worth of assets based on discounted cash flow projections of the present value of interest and principal payments.
2. If permanently distressed, write down the assets as appropriate, based on reduced or omitted interest and/or principal payments.
3. Subject all asset write downs and valuation to external auditor reviews.
4. Further subject all asset write downs to bank examiner reviews.