Accounting: Bringing the Future into Play

Why economists like accounting based on market values

Accountants are under attack as never before. In case after case, they have been accused of trading consulting fees for lenient audits and signing off on misleading numbers.

But from the perspective of economic efficiency, there's a deeper problem that may have greater consequences: Accountants mostly ignore the future. They dwell on historical data, such as how much was paid in wages over the past year or what it cost to build a certain factory 10 years ago.

By contrast, investors care about how a company will do in the future. Accountants could shed far more light there by measuring the current rather than the historical value of a company's assets and liabilities, from long-term energy contracts to junk-bond debt. Current value represents the best judgment available today about how much a company's assets can earn in the future, as well as how much of a burden its liabilities will be. The trouble is, current value is often a hard number to determine--and accountants hate making estimates. "Your typical accountants are unlikely to sign their names to something speculative," says Robert E. Litan, director of economic studies at the Brookings Institution.

Now, the pressure on accountants is building. Good numbers are crucial for allocating capital to projects that will create the most value. Should accountants preserve accuracy at the cost of irrelevance? Or pursue relevance at the cost of accuracy?

The heart of the issue is "marking to market"--that is, recording assets and liabilities on the company's financial statements at current value. That's not difficult or controversial in the case of marketable securities such as shares of stock. But when there is no market price available, as with most derivatives or commercial loans, marking to market requires making assumptions about future returns.

In theory, there is no controversy--the more current the information, the better. Because marking to market gives the most realistic snapshot of a company's financial condition, it helps investors make the right decisions. Publicly stating current values also means that managers can't conceal failing businesses or sit on unrealized gains. That speeds up the closing down of money-losing businesses, and it gets valuable assets into the hands of the companies that can use them best. Says Paul B.W. Miller, a professor at the University of Colorado at Colorado Springs: "The economy is going to be better off if decisions are made on the basis of market values, not old numbers."

On the other hand, marking to market isn't a pure plus for the economy. For one thing, it could scare investors away from worthy businesses that are forced to incorporate wildly fluctuating market data into their financial statements. It could create tons of paperwork. And when companies get to value assets based on their own complicated valuation models and their own assumptions about the future, the resulting numbers are potentially open to abuse. Enron Corp., for example, manipulated its forecasts of energy prices to maximize the value it booked for long-term gas and electricity contracts--and its auditor, Arthur Andersen, signed off.

"Andersen put their name on wild guesses," says George J. Benston, a professor of finance, accounting, and economics at Emory University's Goizueta Business School. "The thing that an accountant is selling is integrity and reliability, and not `What is this company really worth?' That is not what an accountant is good at."

While acknowledging that marking to market isn't an economic panacea, backers are cautiously pushing to increase its use in financial statements. Derivative contracts are already marked to market, and the Financial Accounting Standards Board is on record in favor of ultimately marking to market all financial assets and liabilities, such as bank loans and deposits. FASB--the keeper of generally accepted accounting principles--has important allies, including the Securities & Exchange Commission and foreign financial regulators. Most other countries do more marking to market than America does, so a change by the U.S. would improve comparability of results between American and foreign companies.

Employee stock options can also be valued as a compensation expense when issued using mark-to-market techniques. Several years ago, FASB lost a fight to do just that. But that issue may pop back onto the agenda. Indeed, on Feb. 26 the International Accounting Standards Board, an advisory group, stated that employee stock options are expenses.

Stepping back from the nitty- gritty, the best argument for mark-to-market accounting is that it helps society allocate capital more efficiently by improving financial understanding. As an experiment, accounting professor Eric Hirst of the University of Texas at Austin and two other researchers asked 80 buy-side securities analysts to study three presentations of the financial statements of a pair of imaginary banks. All three presentations contained the same data, but two relegated the mark-to-market information to footnotes. Only when the analysts were given the third presentation, with full-blown marking to market, did they zero in on the key fact that one of the banks' profits would be affected much more by a change in interest rates.

Is there a way to capture the economic benefits of marking to market without running the risk of exaggeration and fraud by insiders? Advocates say yes. One idea is to have the markings performed by outsiders who don't have a vested interest in making the numbers look good. Kiodex Inc., a New York-based startup run by former Wall Street energy traders, is in that budding business. Another idea is to publicize the assumptions that went into estimating values, so the assumptions themselves can be audited. Yet another is to report ranges of potential asset values, which would highlight the iffiness of forecasts while still giving investors useful information.

Most important, FASB intends to limit mark-to-market accounting to financial assets and liabilities, which are less prone to manipulation. It allows other items on the balance sheet to be marked down in value, but never up. That goes for goodwill, inventories, intangibles, fixed assets, and real estate. Purist economists argue that it's "asymmetrical" to spermit values of many assets to be decreased but never increased. But accounting experts respond that the rule prevents unjustified markups of assets. Ray Ball, editor of the Journal of Accounting Research at the University of Chicago Graduate School of Business, says that CEOs will be sure to alert investors if a key asset has increased in value, even if they can't show it on the balance sheet. Says Ball: "You can count on them to shout it from the highest hilltops."

Bankers argue that they shouldn't have to mark to market the assets that they intend to hold to maturity. "It will actually be misleading," says Donna Fisher, tax and accounting director of the American Bankers Assn. "If the bank's going to hold on to that loan, then there's no reason to have the market's perception of value flowing through the bank's financial statements."

But economists and accounting professors say that even assets that are held to maturity have a current value that should be measured. Says Colorado's Miller: "If there's value and you choose not to sell it, then that's making a decision. Every day. And that's a poor way to do business."

In the long run, Miller says, appropriate use of mark-to-market accounting could lower the cost of capital for U.S. firms by increasing investors' confidence that they understand companies' finances. Marking to market is far from perfect. But for the good of the economy, it's better to be approximately right than exactly wrong.

By Peter Coy in New York

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