Re-jigging the mark-to-market rule

I don't really want to say, "I told you so" on the mark-to-market rule being impracticable and unhelpful, but....

As may would be aware, on 1st January 2010, Malaysia, in line with the entire world, adopted the mark-to-market rule, also known as FRS139.

Just to recap on FRS139 as extracted from this article:

Derivatives (e.g. foreign exchange contracts, options) and many financial assets such as investments in shares and debt securities are now required to be stated at fair value. The standard also introduces complex hedge accounting and impairment rules.

But, what's happening now?

The IASB is, however, currently undertaking a comprehensive review of financial instruments accounting and aims to replace IAS39 with a new financial instruments standard referred to as IFRS9 Financial Instruments.

The IFRS9 project is partly driven by requests for reform from the Group of 20 and other constituents. The IFRS9 project is divided into three main phases: classification and measurement, impairment, and hedge accounting.

The IASB aims to complete all phases by the second quarter of 2011. To date, the classification and measurement phase has been completed and draft proposals arising from the impairment phase have been issued.

Under the classification and measurement phase, the four categories for financial assets under IAS39 (namely held to maturity, loans and receivables, fair value through profit or loss, and available for sale) are replaced by just two categories i.e. amortised cost and fair value.

An entity’s “business model” condition is introduced to determine the appropriate classification for financial assets. If an entity’s business model’s objective is to hold assets to collect the contractual cashflows, then the financial assets are measured at amortised cost.

This change is intended to make it easier for entities to measure their financial assets (particularly quoted debt securities) at amortised cost rather than fair value. Hence, unlike previously, an entity does not have to hold all debt securities to maturity to qualify for amortised cost measurement.

Other key changes

There are also key changes in the accounting for investments in equity investments (shares).

Equity investments are generally measured at fair value and gains/losses on fair value changes are recognised in profit or loss. However, an entity may elect to present the fair value changes to other comprehensive income (OCI) instead. The election is irrevocable and can be made on an individual share-by-share basis.

Well, it's just an agonizing waste of time and resources.

This is the downside to having capital markets that keep inventing ways to create false wealth that has nothing to do with the brick-and-mortar real world of the real economy where people generate actual goods and services and receive a fair wage and return.

They call the invented wealth "derivatives", i.e. imaginary financial products that are derived from actual equity and financial instruments. That, if you trouble yourself to take a reality check, is all about creating illusions.

And, the greatest economic minds in the Western world are still puzzling over how to pick up the pieces when these illusory products are proven to be just that ... illusions that go "PUFF!!!" into thin air at the first sign of trouble.

How do you measure the value of that?

Accounting Bonanza

The next 3 years will be a bonanza for the accounting fraternity.

First, the fair value accounting regime under FRS 139 will come into force on 1st January 2010. Lots of additional compliance work there.

Second, in the next following year GST is expected to come onstream. So, 2010 will be a frenetic year with clients running helter-skelter to put in place additional compliance procedures.

There's several hundred million Ringgit worth of billable work there. Good times.

If only the Securities Commission and Bursa Malaysia can come up with a special "Services Board" to enable accounting firms to list some equity-type interests for the rest of the investing public to get in on the action...

Fair value accounting unfair?

Don't worry about this particular entry. I've been examining the issue of "mark-to-market" and "fair value accounting" for some time. These accounting rules are being debated heatedly in the U.S. and Europe. I've done some previous posts on this under the label "Mark-to-Market Rule". It is something you can click on if you have lingering symptoms of insomnia and, if you find that Perry Como and Mantovani isn't able to cure your predicament. I am just pasting this piece by Stephen Oong from Ernst & Young as published in The Star for my own reference. You will find this matter becoming more and more prominent in the coming months because the accounting profession in Malaysia has determined that from January 1, 2010 (that would be some 3 months away), Malaysian corporates must adopt this rule in measuring the value of their assets.

FAIR value accounting has been the subject of intense scrutiny and debate in the uncertainty of the current economic times. Under such conditions, the fair values of certain assets and liabilities are more volatile, causing the income statements of some companies to be more volatile too. Certain quarters are of the view that fair value accounting is the main culprit behind the poor performance of many of the worst affected companies. Or is fair value accounting a mere bearer of the bad news?

Fair value accounting is a financial measurement methodology whereby companies are permitted or required to measure certain assets and liabilities at fair value or market value. Under fair value accounting, companies report losses when the fair values of their assets decrease or liabilities increase. The gains or losses are reflected directly in the income statements or sometimes in the statement of equity changes.

Companies in Malaysia are very familiar and comfortable with using fair value accounting. For many years, Malaysian companies have been applying fair value accounting in the measurement of certain permissible items and transactions in their financial statements. Such applications are allowed for by our Malaysian accounting standards. Why then the sudden spate of criticism on fair value accounting? Could it be that fair value accounting is not fair?

Fair value accounting is accused of being pro-cyclical. In periods of growth and during downturns, fair value accounting accentuates the volatility of the financial statements. When assets are measured at their respective fair values, rising or falling values will be reflected in the financial statements of the company and such swings could move in a cyclical fashion.

Fair value accounting appears harsh when prices are going down; yet no one complains when asset values are rising. However, fair value accounting is merely reporting and reflecting the outcomes of market forces at play, not causing them.

When market conditions result in volatility in values and earnings, users of financial statements benefit when companies transparently report these circumstances and their impact on financial reporting. Users of financial statements would like to know the financial position of a company based on its current value rather than some old historical costs.

Although the information contained in the balance sheet is reliable (because it is based on verifiable historical costs) and not subjective, it is irrelevant, and accordingly not useful, for decision-making purposes.

Assets acquired years ago and newly-acquired assets do not have the same costs and hence have different carrying values, even though their respective current values may be the same. To account for such assets in the financial statements of different entities at their respective historical costs would make comparisons between companies almost impossible.

Historical cost information for assets has no economic relevance to the buy, sell, hold decisions that management must make each day. However, making economic decisions using fair values may also be inappropriate because the fair values used may not be reliable, but at least they may not be totally wrong all the time.

The support for the use of the fair value approach is principally grounded on relevance. The adoption of fair value as the primary basis of measurement should be tested explicitly against the four attributes that make information in financial statements useful to users: understandability, relevance, reliability and comparability. However, information needs to pass a reliability threshold before it can be considered relevant.

In this respect, fair values based on prices quoted in an active market will pass both the reliability and relevance attributes. However, a source of discomfort among the fair value dissenters is when assets and liabilities are not quoted in an active market; or when there are infrequent or no transactions for the kind of assets or liabilities held by the entity.

Under FRS, in such illiquid market situations, companies are to use adjusted mark-to-market measurements based on observable market prices for similar assets and liabilities. Where such market observable data is not available, FRS suggests the use of acceptable valuation models to estimate fair value (mark-to-model measurement). Such adjusted mark-to-market and mark-to-model basis of determining fair value is what users of financial information are not comfortable with.

In any adjusted mark-to-market models and valuation models, the output is only as relevant and reliable as the input. Because the assets are in an illiquid market, input using market observable data is hard to come by. Companies would therefore have to rely heavily on the estimation of future cashflows and to use input based on non-observable best estimates and best judgments.

So can valuations that are not independently verifiable be considered reliable? And is information that is not reliable relevant in the world of financial reporting? Under such circumstances, the financial statements produced using fair values may be more relevant (vis-à-vis historical costs) but one cannot be so sure about its reliability either.

Relevance and reliability are the two key attributes of financial reports that are useful to readers. However, these attributes could be compromised by the use of adjusted mark-to-market and mark-to-model calculated fair values.

That is why it is important that companies make adequate and robust disclosures in their financial statements as to the valuation processes and methods used in determining fair values, what the significant estimates are and the assumptions used as inputs.

The balance sheet prepared using fair value as a basis of measurement gives a better reflection of the actual worth of the company. Until and unless another better basis of accounting measurement can be identified, fair value accounting is still the fairest option available.

How the Mark-to-Market Rule affects Economic Recovery

I have written about the mark-to-market rule aka fair value accounting on several occasions here.

Economic policy-makers should pay heed to the view that the mark-to-market rule (for easy writing I dub it the "m2m rule") hinders economic recovery efforts. I take this view.

Basically, the m2m rule requires accountants in banks and corporations to review the value the assets of securitised assets and assets of corporations based on prevailing market prices.

How the m2m rule affects economic recovery efforts
One of the key factors that affect economic stimulus packages in Western counties, particularly, the U.S., has been the valuation of securitised assets in the books of banks. I have offered one radical solution of legislating to fix the valuations of toxic assets here. So far, no takers.

There are 2 areas where the m2m rule has an adverse effect on economic recovery efforts:

First, in a contracting economy banks that comply with the m2m rule will constantly be downgrading the valuation of securitised assets. When this is coupled with the borrower company's poor sales turnover and declining profits, it can only mean that when the risk management software kicks in, the banks will want the borrower to top-up the securitsation. Worse still, the banks may regard the loan as non-performing. The loan becomes an NPL.

To be fair, Bank Negara has agreed that Malaysian banks defer the m2m rule. I have forgotten how long the deferment is for.

Second, the m2m rule will impact publicly-listed companies ("PLCs") at Bursa Malaysia. If the time-table set by the Malaysian Accounting Standards Board ("MASB") is strictly adhered to, by Jan 1, 2010 the m2m rule will kick in for most key Malaysian business sectors. When this happens, there is a strong possibility that it will have an adverse effect on economic recovery efforts.

Why?

Accountants and the Bridge Over The River Kwai Syndrome
The global accounting fraternity has worked very hard since one of their greats, Arthur Andersen died an unnatural death in the wake of the Enron and Worldcom scandals.

The m2m rule is the fruition of hundreds and thousands of man-hours of committee- and sub-committee meetings by accounting standards boards throughout the world. Officially, the m2m rule is known globally as International Accounting Standard (IAS) 39 or, in Malaysia as Financial Reporting Standard (FRS) 139.

After such a Herculean effort, where the accounting fraternity even managed to rope in the U.S., to agree to the accounting standard the accounting fraternity will not yield easily to the deferment of the m2m rule.

As recently as in this month's issue of In the Black, the magazine for CPA Australia, its CEO Geoff Rankin wrote in defence of the m2m rule. In November last year, the ACCA had supported MASB's defence of the time-table for the m2m rule.

I call this the Bridge Over The River Kwai Syndrome. A case where, after so much effort being put into an endeavour, one cannot imagine changing or, re-directing or, defering the implementation of the end-product.

Where the m2m rule fails
My proposition is that the m2m rule only works when there is a stable economic environment. Where economies expand and contract in the ordinary course of cyclical movements, the m2m rule works quite well, I think.

The m2m rule is intended to ensure that all stakeholders of banks and corporations have accurate financial information in order to formulate their business plans and investment decisions.

The m2m rule fails when there is a very dire economic situation such as the one confronting the whole world.

Let's be frank. The m2m rule, to paraphrase the Jack Nicholson character in the movie As Good As It Gets, only describes the water when everyone is drowning. Geoff Rankin's analogy was that just as you can't blame the thermometer for the Australian heatwave, you can't blame the m2m rule for the economic crisis.

Is that accurate?

The nightmare scenario is that the m2m rule creates a self-fulfilling prophecy. It triggers off a pro-cyclical vicious cycle at a time when economic policy-makers are trying to create a counter-cyclical virtuous cycle through economic stimulus packages.

The dilemma is that accountants, being fearful of tortious and statutory liabilities, will adopt a conservative stance and refuse to exercise broader judgement in applying the m2m rule. The International Accounting Standards Board (IASB) has, in the wake of the U.S. fiasco, attempted to stress the importance of the use of judgement in applying the m2m rule by releasing guidance in October 2008 on how to determine fair value when markets are illiquid. But, such guidance ring hollow to accountants who would naturally prefer to exercise zero judgement i.e. take a very conservative view on fair valuation rather than to run the gauntlet of liabilities for having exercised broader judgement.

So, I say, please defer the implementation the the m2m rule until genuine economic recovery kicks in.

One final reminder, the MASB deadline for the full implementation of the m2m rule is Jan 1, 2010.

Spending other peoples' money

When I first heard about the new bunch of barracudas called private equity some years back, I had the worst possible feeling. It's a group of investment bankers and stockbrokers who decided that they needed to move away from the straitjacket of regulations that licensed investment bankers and stockbrokers are subjected to constantly.

You may say that given the financial markets turmoil, even regulations failed. Fair enough. But, private equity firms were also contributory.

If ever there was an new embodiment of reckless greed it would have to be the high net worth individuals who put substantial amounts of their wealth into private equity funds.

The difference between private equity funds and funds operated by investment banks and financial institutions is that the former is completely unregulated. It is governed purely by private contracts signed between the private equity firm and the high net worth individuals.

I haven't seen any such contracts but I would imagine that the wily private equity people must have templated the standard contracts filled with exclusion clauses used by the licensed investment banks and financial institutions except that the private equity investment contracts probably had more trapdoors.

Now the investors of private equity funds have to hang on for their dear financial lives. You can't sue, you can't sell. I feel like a financial version of Simon Cowell berating the investors.
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The unkindest cut may be the mark-to-market rule that I have blogged about innumerably. No more true and fair bullcrap. The new accounting rules will force the private equity funds to state it like it is, serious diminution of value of investments all around.

But, as F. Scott Fitzgerald said, Let me tell you about the rich. They are different from you and me. So, there's no need for any concern about them. One less jar of caviar. One less Ferrari. Oh, well, back to using the Rolls, then.

Wonderful device, private equity. In every decade, there are new ways for spending other peoples' money. In this decade, private equity is it.

For a slightly different take on this, read this Economist piece.

ACCA backs mark-to-market accounting

KUALA LUMPUR: The Association of Certified Chartered Accountants (ACCA) has come out in support of a Malaysian decision to adopt an accounting standard that makes it mandatory for publicly listed companies to value financial instruments in their books according to fair market value.

ACCA global president Richard Aitken-Davies said the adoption of International Accounting Standard 39 (IAS 39) — accounting for financial instruments — would better reflect the globalised nature of the world’s economy, and, if properly implemented, could provide greater risk disclosure.

“We (ACCA) support the standard and in fact, there was a lot of pressure on the International Accounting Standards Board (IASB) to abandon the fair value mark-to-market for this type of asset or liability,” he told The Edge Financial Daily.

“We resisted that. We believe that the concept of fair value is essentially right because what it does is give investors and other stakeholders an assessment at a certain point in time what their assets and liabilities are.

“What fair value tries to do is to record what’s happened in the organisation and give an indication as to what that means for the future of the company. Fair value, properly implemented, gives enhanced information to people who have invested in the company and to people who may want to invest in the company.”

Presently, only financial institutions in Malaysia are required to mark to market the financial instruments in their books. By 2010, all publicly listed companies would be required to adopt IAS 39 in line with the country’s efforts to fully adopt IAS.

However, not everyone is happy with the proposal. Critics argue that the implementation of IAS 39 might aggravate volatility in markets because otherwise healthy companies would be required to write down bad assets in their books.

Responding to the concern, Aitken-Davies said the solution was to require firms to make more concerted efforts to disclose risks and educate their investors about the company’s health.

Read more here.

Maybank and the Mark-to-market Rule

The Star Online report on the travails of Maybank's corporate indigestion over its acquisition of PT Bank Internasional Indonesia (BII) first announced in March and, a 20% stake in MCB Bank of Pakistan announced in May leads in to the topic of my interest today.

It is about the mark-to-market accounting rule contained in what is known globally as International Accounting Standard (IAS) 39 or, in Malaysia as Financial Reporting Standard (FRS) 139. What is that, you ask?

FRS 139 is an accounting standard that requires companies or banks to adopt fair value accounting in valuing financial instruments in their books. I stand to be corrected, but, as I understand it, FRS 139 requires company auditors to use the prevailing market price of equities and instruments owned by companies or banks as the true and fair value of those assets.

At the moment, the controversial mark to market ruling in relation to accounting principles is confined to the financial sector.

But come Jan 1, 2010, the ruling will apply to all industries across the Malaysian economy, from finance and plantations to construction.

On that day, all listed companies in Malaysia will have to comply with the FRS 139. The Malaysian Accounting Board of Standards (MASB) is reported on October 13, to have finally given an ultimatum on the date of its implementation after deferring it to enable companies to get ready for the much-talked-about standard.

Maybank's risk of impairment losses
The Star Online's report goes on to say, In a sense, the acquisitions have become casualties of circumstances as global asset prices plummeted further in the last couple of months.

Maybank’s investments in the two countries are sizeable. It has spent RM5.5bil for a 71.86% stake in BII and a mandatory general offer for the rest of the shares would probably draw all minority shareholders to accept. Maybank’s offer, which closes on Nov 19, is 510 rupiah a share compared with BII’s price of 455 rupiah yesterday, which would probably have been much lower if not for the offer.

Full acceptance to the offer would cost Maybank an additional RM2.4bil for the balance of 28.14% of BII. Its cost would then be about RM7.9bil for the whole of BII.

Maybank’s purchase of a 20% stake in MCB Bank for a total of RM2.87bil was completed in August. Its cost was about 470 rupees a share compared with MCB’s price of 235.75 rupees yesterday. In total, Maybank would have spent about RM10.8bil cash for its investments in the two banks.

The FRS 139 mark-to-market rule will require Maybank to state the investment value based on the current market values and prices as at the date when it closes its accounts in each quarter. This is where the impaired value of the BII and MCB Bank investments will send Maybank's board of directors running for cover and, when shareholders, analysts and the general Malaysian public go super-ballistic.

A perspective: Defer the mark-to-market rule
Let's leave the Maybank investment saga for the other hyenas to devour. I'm more interested in looking at the bigger picture about FRS 139.

MASB's members are quoted as saying that the need to establish the IFRS framework is imperative to ensure Malaysia is not left out of the globalisation wave, especially since more than 100 countries are converging or have converged with it.

Let's pause here for a bit. Let's wear our Malaysian hat instead of the globalisation hat. Let's be a bit nationalistic and look at what's best for Malaysia now.

If you've read the various posts in this blog and many in the blog list, it is quite evident that Malaysia is not immune to the economic turmoil that is now threatening to spill over from the Malaysian capital market into the real economy.

In this context, would it not be a wiser strategy for MOF1 or MOF2 to pick up the telephone to call MASB's chairman Datuk Zainal Abidin Putih and MASB to defer the application of FRS 139.

The forex market is behaving irrationally. The capital market is behaving irrationally. In the US, Europe and Australia, the financial markets are behaving irrationally.

So, what would the mark to market rule be marking the values at? Obviously depressed prices. Is that a true and fair valuation? I don't think so.

Do you think I'm being absurdly out-of-the-box again?

A further perspective: US defers the mark-to-market rule
In the wake of the Wall Street financial and market turmoil, it has been alleged that the mark-to-market rule played (and, is playing) a significant role in the crisis.

Whether this is true or not is difficult to conclusively prove. Certainly the proximity of the mark-to-market rule (called FAS 157 in the US) going into effect and the credit crisis made the US regulators suspicious. And logically it appears that the mark-to-market rule could have a deleterious effect on Wall Street's sentiments.

To be more specific, Section 132 of the US Emergency Economic Stabilization Act of 2008, titled Authority to Suspend Mark-to-Market Accounting restates the Securities and Exchange Commission (SEC)’s authority to suspend the application of the mark-to-market rule if the SEC determines that it is in the public interest and protects investors.

Furthermore, Section 133 of the Act, titled Study on Mark-to-Market Accounting, requires the SEC, in consultation with the Federal Reserve Board and the Department of the Treasury, to conduct a study on mark-to-market accounting standards as provided in FAS 157, including its effects on balance sheets, impact on the quality of financial information, and other matters, and to report to Congress within 90 days on its findings.

The US Emergency Economic Stabilization Act of 2008 was passed, and signed into law on October 3, 2008.

On September 30, 2008, the SEC and the FASB issued a joint clarification regarding the implementation of fair value accounting in cases where a market is disorderly or inactive.

This guidance clarified that forced liquidations are not indicative of fair value, as this is not an orderly transaction.

Further, it clarified that estimates of fair value can be made using the expected cash flows from such instruments owned by the financial institutions, provided that the estimates reflect adjustments that a willing buyer would make, such as adjustments for default and liquidity risks.

My message is:
Put Malaysia first, globalisation second.

Market turmoil: Assailing the "true and fair view" doctrine

As with most market turmoils, the accounting profession and, more particularly, accounting standards that deal with valuation, has been put in the spotlight again. 3 issues have been cited.

The first of these concerns “procyclicality”. Bankers say that in a downturn fair-value accounting forces them all to recognise losses at the same time, impairing their capital and triggering firesales of assets, which in turn drives prices and valuations down even more. Under traditional accounting, losses hit the books far more slowly. Some admire Spain’s system, which requires banks to make extra provision for losses in good times, so that when loans turn sour their profits and thus capital fall by less.

The second—and immediate—question is how to value illiquid (and sometimes unique) assets. A common solution is to use banks’ own models. But some investors are concerned that this gives banks’ managers too much discretion—and no wonder, because highly illiquid (or “Level 3”) assets are worryingly large relative to many banks’ shrunken market values. Such is the complexity of many such assets that it may not be possible to find a generally acceptable method. The best answer is to disclose enough to allow investors to form their own views.

The third problem is a longer-term one: the inconsistency of fair-value rules. Today the treatment of a financial asset is determined by the intention of the company. If it is to be traded actively, its market value must be used. If it is only “available for sale” it is marked to market on the balance sheet, but losses are not recognised in the income statement. If it is to be “held to maturity”, or is a traditional loan, it can be carried at cost, subject to impairment. This is a dog’s breakfast. Different banks can hold the same asset at different values.

Rather than indulge in a deadly analysis of the fascinating area of what constitutes "true and fair" value, which may actually be a cure for insomnia and, create new precedents in medical science by introducing gas-less anasthesiology, I would much rather that you read The Economist piece yourself here.