Entrepreneurship Finance Global Mobility & Security Human Capital Leadership Managing Organization & Logistics Sales & Marketing Technology & Productivity Reality Check

Finance

The Perils of Derivatives and Fair-Value Accounting

Accountants are grappling with how to assess “fair-value” on defunct sub-prime mortgage funds.

Published on: Tuesday, November 20, 2007 Comments (0) Category: Finance,

Posted by: Economist.com

When the subprime mortgage market froze and assets became illiquid at best, accountants began to face the first big hurdle of this economic challenge. As The Economist Magazine reported (7/19/07), even though investors could now say “there is effectively no value left” in the funds, accountants are grappling with the question, �how to put a value on the instruments that got them into trouble.

Traditionally, a company’s accounts would record the value of an asset at its historic cost (ie, the price the company paid for it). Under so-called “fair value” accounting, however, book-keepers can now record the value of an asset at its market price (ie, the price the company could get for it). But many complex derivatives, such as mortgage-backed securities, do not trade smoothly and frequently in arm’s length markets. This makes it impossible for book-keepers to “mark” them to market. Instead they resort to “mark-to-model” accounting, entering values based on the output of a computer.

Unfortunately, the market does not always resemble the model. When the Bear funds ran into trouble, their bankers tried to sell their collateral, which was mostly in the form of mortgage-backed derivatives. As well as raising cash, such a sale would have had the side-effect of setting a true market price for these hard-to-value instruments. But the bankers worried that if the derivatives were sold into a falling market, the low price would set an ugly precedent for their own portfolios. The disclosure of fire-sale prices could force them to slash carrying values on their own books. This in turn would spur more selling, driving prices further down in a vicious cycle. In the end, the bankers decided that they would rather hold the toxic investment.

Situations like this, says Ray Beier at PricewaterhouseCoopers, reach “the heart of the fundamental challenge in fair-value accounting”. Models are supposed to show the price an asset would fetch in a sale. But in an illiquid market, a big sale can itself drive down prices. This can sometimes create a sizeable difference between �mark-to-model� valuations and true market prices.

That is not the only problem with fair-value accounting. According to Richard Herring, a finance professor at the Wharton School, “models are easy to manipulate”. RiskData, a consultancy, studied more than 1,000 hedge funds and concluded that nearly a third of funds trading illiquid securities were smoothing the results of their models, so as to iron out too much volatility in their books.

Unfortunately, the alternatives to fair-value accounting can be worse. Historic cost may be harder to manipulate than the results of a model. But as Bob Herz, chairman of America’s Financial Accounting Standards Board, points out, it too is “replete with all sorts of guesses”, such as depreciation rates. And for derivatives, historic cost accounting is patently wrong. The historic cost of employee stock options, for instance, is zero.

Fair value is perhaps most worrying for auditors, who are often blamed for faulty accounts. Faced with murky models, the best they can do is examine assumptions and ensure disclosure. Mark Olson, chairman of the Public Company Accounting Oversight Board, a regulator, expressed his unease last month. “Valuation requires training,” he said, “and many auditors may not have extensive training.” Investors, in other words, are on their own.

Read Less...

Comments (0)

Hewitt Expects 3.8% Increases; Execs Reported 7.6% to ExecuNet

ExecuNet’s ongoing analysis of executive compensation issues found that those who were directors and above in organizations expected to receive 7.6 percent increases in 2007, and those at the highest level � CEO and President � awaited 10.2 percent raises.

Published on: Wednesday, October 31, 2007 Comments (0) Category: Finance, Leadership, Sales & Marketing,

Posted by: Robyn Greenspan

Human resources consultants Hewitt Associates’ survey of 1,007 large organizations indicates base salary raises will be nearly flat in 2008 � 3.8 percent compared to 3.7 percent in 2007 and 3.6 percent in 2006.

The jackpot for many employees, according to Hewitt, will be in variable pay plans, which can push salaries beyond the expected 3.8 percent increase. Sixty-three percent of the surveyed companies offer special recognition awards to employees; 59 percent have a business incentive program; 44 percent grant individual performance awards; 44 percent offer non-executive equity awards; and 38 percent give retention bonuses to employees.

Let’s Do Business

Word Bank releases �Doing Business 2008,� ranking the most business-friendly countries in the world:

Published on: Thursday, October 11, 2007 Comments (1) Category: Entrepreneurship, Finance, Global Mobility & Security,

Posted by: Economist.com

Singapore is the most business-friendly country in the world, according to the World Bank’s �Doing Business 2008� report published on Wednesday September 26th. The bank ranks 178 countries using measures including labour-market flexibility, the complexity of trading across borders and access to credit. One indicator of red tape is how long it takes to open a business. In Congo an entrepeneur would have to wait 155 days and spend five times the annual income per head. Countries that simplify regulations see results. Saudi Arabia reduced the time from 39 days to 15, resulting in an 81% increase in new businesses. Egypt, Georgia and Croatia are among the most enthusiastic reformers.