The May 2008 issue of The Journal of Accountancy ran opinion pieces on the role of accounting in the subprime crisis and subsequent bursting of the credit market bubble. Paul Miller was invited to comment on a controversial claim that mark-to-market practices made things worse. The critics claim that GAAP practices weakened institutions that invested in collateralized debt obligations by revealing large losses when the CDOs’ market values evaporated.They assert that financial statements would better serve the public interest if managers can keep unrealized losses (which they consider to be unreal) out of their financial statements. By a huge leap of ego, they conclude that they and everyone else would be better off if nobody is aware that those losses had occurred. After all, everyone knows they aren’t real because they are always followed by gains. Except when they aren’t, of course.

To agree with that, one has to swallow the proposition that biased managers are better than objective markets at predicting the future for their tattered and torn debt instruments. Maybe it’s just us, but that idea strikes us as irrationally exuberant ... .

Paul’s article, titled “The Capital Markets’ Needs Will Be Served,” is reprinted below.

With regard to the relationship between financial accounting and the subprime lending crisis, I observe that the capital markets’ needs will be served, one way or another.

Grasping this imperative leads to new outlooks and behaviors for the better of all. In contrast to conventional dogma, capital markets cannot be managed through accounting policy choices and political pressure on standard-setters. Yes, events show that markets can be duped, but not for long and not very well, and with inevitable disastrous consequences.

With regard to the crisis, attempts to place blame on accounting standards are not valid. Rather, other factors created it, primarily actors in the complex intermediation chain, including:

* Borrowers who sought credit beyond their reach.

* Originators who wrote subprime mortgages to collect fees.

* Investment bankers who earned fees for bundling and selling vaporous bonds without adequately disclosing risk.

* Institutional investors who sought high returns without understanding the risk and real value.

In addition, housing markets collapsed, eliminating the backstop provided by collateral. Thus, claims that accounting standards fomented or worsened this crisis lack credibility.

The following paragraphs explain why fair-value accounting promotes capital market efficiency.

THE GOAL OF FINANCIAL REPORTING

The goal of financial reporting, and all who act within it, is to facilitate convergence of securities’ market prices with their intrinsic values. When that happens, securities prices and capital costs appropriately reflect real risks and returns.

This efficiency mutually benefits everyone: society, investors, managers and accountants.

Any other goals, such as inexpensive reporting, projecting positive images, and reducing auditors’ risk of recrimination, are misdirected. Because the markets’ demand for useful information will be satisfied, one way or another, it makes sense to re-orient management strategy and accounting policy to provide that satisfaction.

THE PRESCRIPTION

The key to converging market and intrinsic values is understanding that more information, not less, is better. It does no good, and indeed does harm, to leave markets guessing. Reports must be informative and truthful, even if they’re not flattering.

To this end, all must grasp that financial information is favorable if it unveils truth more completely and faithfully, instead of presenting an illusory better appearance. Covering up bad news isn’t possible, especially over the long run, and discovered duplicity brings catastrophe.

SUPPLY AND DEMAND

To reap full benefits, management and accountants must meet the markets’ needs. Instead, past attention was paid primarily to the needs of managers and accountants and what they wanted to supply, with little regard to the markets’ demands. But progress always follows when demand is addressed. Toward this end, managers must look beyond preparation costs and consider the higher capital costs created when reports aren’t informative.

Above all, they must forego misbegotten efforts to coax capital markets to overprice securities, especially by withholding truth from them. Instead, it’s time to build bridges to these markets, just as managers have accomplished with customers, employees and suppliers.

THE CONTENT

In this paradigm, the preferable information concerns fair values of assets and liabilities. Historical numbers are of no interest because they lack reliability for assessing future cash flows. That is, information’s reliability doesn’t come as much from its verifiability (evidenced by checks and invoices) as from its dependability for rational decision-making. Although a cost is verifiable, it is unreliable because it is a sample of one that at best reflects past conditions. Useful information reveals what is now true, not what used to be.

It’s not just me: Sophisticated users have said this, over and over again. For example, on March 17, 2008, Georgene Palacky of the CFA Institute issued a press release, saying, “Fair value is the most transparent method of measuring financial instruments, such as derivatives, and is widely favored by investors.” This expressed demand should help managers understand that failing to provide value-based information forces markets to manufacture their own estimates. In turn, the markets defensively guess low for assets and high for liabilities. Rather than stable and higher securities prices, disregarding demand for truthful and useful information produces more volatile and lower prices that don’t converge on intrinsic values.

However it arises, a vacuum of useful public information is always filled by speculative private information, with an overall increase in uncertainty, cost, risk, volatility and capital costs. These outcomes are good for no one.

THE STRATEGY

Managers bring two things to capital markets: prospective cash flows and information. Their work isn’t done if they don’t produce quality in both. It does no good to present rosy pictures of inferior cash-flow potential because the truth will eventually be known. And it does no good to have great potential if the financial reports obscure it.

Thus, managers need to unveil the truth about their situation, which is far different from designing reports to prop up false images. Even if well-intentioned, such efforts always fail, usually sooner rather than later.

It’s especially fruitless to mold standards to generate this propaganda, because readers don’t believe the results. Capital markets choose whether to rely on GAAP statements, so it makes no sense to report anything that lacks usefulness. For the present situation, then, not reporting best estimates of fair value frustrates capital markets, creates more risk, diminishes demand for a company’s securities and drives prices even lower.

THE ROLE FOR ACCOUNTING

Because this crisis wasn’t created by poor accounting, it won’t be relieved by worse accounting. Rather, the blame lies with inattention to CDOs’ risks and returns. It was bad management that led to losses, not bad standards.

In fact, value-based reporting did exactly what it was supposed to by unveiling risk and its consequences. It is pointless to condemn the Financial Accounting Standards Board for forcing these messages to be sent. Rather, we should all shut up, pay attention, and take steps to prevent other disasters.

That involves telling the truth, cleanly and clearly. It needs to be delivered quickly and completely, withholding nothing. Further, managers should not wait for a bureaucratic standard-setting process to tell them what truth to reveal, any more than carmakers should build their products to minimum compliance with government safety, mileage and pollution standards.

I cannot see how defenders of the status quo can rebut this point from Palacky’s release: “Only when fair value is widely practiced will investors be able to accurately evaluate and price risk.”

THE FUTURE

Nothing can prevent speculative bubbles. However, the sunshine of truth, freely offered by management with timeliness, will certainly diminish their frequency and impact.

Any argument that restricting the flow of useful public information will solve the problem is totally dysfunctional. The markets’ demand for value-based information will be served, whether through public or private sources. It might as well be public.

Our regular readers will probably recognize many of these points. We can only hope that their airing will get the message in front of others who are unfamiliar with our optimistic view that nothing will bring more economic prosperity than putting the truth, the whole truth, and nothing but the truth in financial reports.

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors’ views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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