Consulting Corner

Why Does Bad Accounting Happen to Good Companies?
by Andrew Davidson

As we approach year end, there is uncertainty in the markets as the dollar sinks against the euro and the yen. There is risk associated with rising rates from the twin deficits. New interest-only loans may pose unforeseen credit risk. Home prices are at all-time highs and could fall if rates rise. In such a difficult environment, what is the focus of financial institutions? How will they deal with the possible contingencies?

These are the problems we hope firms would be addressing, yet many firms are instead focused on FAS-91, FAS-133 and Sarbanes Oxley. Jumping through such accounting hoops dominates much of the time of financial firm executives. Maybe this would be fine if the accounting rules were bringing clarity to investors, but these accounting rules only bring confusion to the presentation of financial results.

FAS-91 is a particularly insidious rule. It creates prospective uncertainty about past amortization of premium and discount. FAS-91 requires that firms show the same level of income as a percent of amortized balance (or internal rate of return) over the life of an investment. As actual and forecast prepayments change, firms must recalculate the amount of amortization taken to date. For premium loans slower forecast prepayments lead to gains and faster forecast prepayments lead to losses. As forecasts rise and fall the same premium is added and subtracted from income over and over.

Maybe FAS-91 was supposed to be the start of the move to mark-to-market reporting. But it isn't that at all; at most it is the mark of premium to a non-market rate. If a loan becomes a market value discount, you would still need to mark up the premium if prepayments are slow, even while the value of the loan is declining.

Much has been written about the flaws of FAS-133, the foremost being that FAS-133 provides disparate treatment for assets, liabilities and hedges (derivatives). While the financial accounting system needed unification, FAS-133 served to further divide the balance sheets of financial institutions. FAS-133 introduces such great uncertainty that many firms have decided not to hedge appropriately rather than face the burdens of FAS-133 bookkeeping or the draconian punishment of potential ineffectiveness. >>>