Mark to Market - McCain is WRONG

Why would anyone encourage a value other than market value be put on a financial statement?

Conservatism - this is why GAAP still relies heavily on historical cost. We acknowledge that it's not the most accurate measurement, but it encourages companies to understate their financial position (which is far better for investors).

If so, who would get to determine it?

The company that created the transaction (i.e., purchase price).

Just like you should not setup a system that encourages high-risk loans to high-risk borrowers, you should not setup a system to hide fair market value to fool investors.

The problem with presenting FMV to non-accredited investors is that they don't always understand the implications. Especially when the FMV is determined by mark-to-model, where most investors cannot adequately evaluate management's assertions.

With that being said, I mostly agree with you. I generally loathe historical-cost principles, especially when there are very accurate FMVs available. However, the emergence of "Level 3" FMV in FAS 157 has and will inaccurately "magnify problems." Illiquid securities (CDOs) will be substantially undervalued, creating large write-offs in the near future.

I would argue that the most accurate measurement is what is best for investors. If I build a house at a cost of $175,000 and can only sell it for $100,000, then my balance should reflect an asset of $100,000. It is not fair to my credit providers if I tell them I'm worth $175,000 because I would be untruthful. A company who reports assets as $175,000 when they are only worth $100,000 is misleading investors.

Pre-FMV GAAP does not stop a company from reporting it for $100,000 - in fact, it requires it. It's called an asset impairment, and it's used to devalue assets whose BV exceeds its FMV.

The problem comes when you try to increase an asset's value based on its market value. In the same scenario, imagine if the RE market is going through an extreme boom - one month your house is valued at $175,000, it doubles in value the next month, and then halves in value (back to its initial $175,000 value) a month later. You will now have reported a fictitious gain of $175,000 and a fictitious loss of $175,000. I say 'fictitious' because even though the value of the asset changed, you had no intention of liquidating the asset.

If we rely entirely on FMV, each asset will have different assumptions for its value. Some assets will be based on historical cost (since no market exists), some will be valued on NPV of CFs, some will be valued on replacement cost, etc. While this problem already exists in financial statements, FMV only increases the problems of reliability and comparability.

If you're constantly updating your books to reflect FMV of illiquid assets, you'll decrease the value of that information. You'll either report everything (including the market volatility for each asset) and overwhelm the investor, or you'll withold useful information (like market volatility and liquidity) in the interest of conciseness.

One of the fundamental prinicples of GAAP is the principle of sincerity.

There are plenty of other fundamental principles that cannot be ignored: measurability, reliability, comparability, conservatism.

It can be a pain to keep track of with high volatility in a market, but it would be the most accurate and it would be (1) sincere (2) measurable (3) reliable (4) comparable.

But it wouldn't be any of those - if it's a highly volatile market, the FMV is hardly reliable. Measurability can be extremely difficult, especially with illiquid, non-commodity assets - you cannot accurately measure the FMV of these assets, since there's no market for them. Further, it's not very comparable - aside from liquid commodities, you'll have inconsistent valuation methods and assumptions between companies and time periods.

Again, if you want to increase the reporting of FMV, you'll have to make a choice about the amount of information you provide investors. You'll either provide them a deluge of information on management's assumptions and model for the value, or you'll withhold that information and provide investors with no method for evaluating the stated FMV.

From my reading of this most recent push (which is greatly impeded by the lack of tangible reporting, and the general inability of journalists to accurately report on accountancy), it appears that they just want to suspend some of FAS 157. I don't think anyone in their right mind would favor eliminating/suspending reporting the FMV of trading securities and other highly liquid commodities, since this practice is and has been common place for quite some time. However, FAS 157 asks companies to determine FMV of assets that do not have an open market value (like CDOs), and most of the prescribed methodology is 1) too complex for most investors to analyze and 2) too reliant on managerial assumptions.

There's huge variability in methodology and assumptions for determining fair value, leading one to question the reliability of reported "fair values." Up until this point, the accounting industry has erred on the side of caution (i.e., conservatism) in reporting values of assets - this is why we don't place any value on internally generated intangible assets (patents, trademarks, etc.), since each company will have completely different methods of determining the value. Until an actual economic event takes place, the "fair value" is simply an educated guess.

If you have asset maturities matched to liabilities then what matters is the expected value at the time of redemption (which includes default probability), not what someone is willing (or unwilling) to buy it for right now.

Actually, these values should be identical.

Even then, the former situation relies far more heavily on estimates and assumptions than the second situation, which is why most people view current market value as a more reliable measure. Look no further than pension accounting to see the problems you encounter when management starts making predictions about their assets.

The two values should converge as maturity approaches, but market fluctuations in the meantime are by definition random.

Actually, the PV should equal the FMV. Why would anyone pay less/more for something than what it's worth? Or have you been talking about the face value? I guess I don't really understand what you're trying to say.

For stocks (no maturity) current price is the best estimate of current value and future price, but that isn't true of fixed income.

Fixed incomes assets are actually valued in the exact same way - their current value is the sum of discounted CFs.

If you have an asset matched to a liability they should cancel out.

I'm sorry, I don't really get what you're saying here. What sort of matching are you talking about?

In this town I am pretty well known for someone who represents financial institutions in recovery of collateral made to secure loans.  In that capacity I am very familiar with foreclosures of houses, bankrutpcy, and recovery of personal property collateral (cars) even for sub-prime lenders.  I also am a Plaintiff in for a sub-prime borrower alleging fraud against a sub-prime mortgage lender (and others) under the Illinois Consumer Fraud and Deceptive Practices Act.  I have been doing this type of law for about 35 years, so I think I may add something to the discussion.

First of all, let me say that there are many factors involved in this government bail out.  It is very difficult to play the moral equivalancy game when you have so many factors,  so I will try to keep this out of poltics (as much as I can) and allow you to draw your own conclusions. 

1.  Regulations-Let's take the IRS Code as an example, since that is not at issue here.  This Code is the statutory federal law on tax.  (3 volumes).   The regulations under the Code (6 volumes), may be administered by the executive branch, but  these are really interpretations of the laws that are passed by Congress.  Regulations interprete laws and these are the responsibility of the congress to approve.  It is true that the various employees of the various departments may be under some Secretary appointed by the President, but if you think that the President or anyone can mess with Civil Service, you would be mistaken.   Since you have two Senators running, and one of them just got there, McCain can  only say that back in 2006 he warned about the Fanny May and Freddy Mac situation-because it was his job to speak up,  despite the fact that the other party was in power.  My point here is that if you did not realize it, regulations are responsbility of the legislature,  although certainly there is oversight and veto authority over code departments.

2.  Bureaucracy- I was on the private panel of US Bankruptcy Trustees from 1974 to 2006.   About 13 years ago, the Legislature decided to provide more oversight over the operation of the trustees and set up the US Trustee system.  They started the process in a few select districts, but soon implemented the system throughout the US.  The cost of filing has risen about 8 times what it was when I started.  There was a small amount of abuse under the older system, but you have just as much abuse as you did before at a much greater cost.  The buracracy is self perpetuating and everyone spends a great deal of time trying to justify their existence.  I have some stories, but since I still practice law, I will just say that no one really has much control over any bueaurcracy.   I will tell you one story, however.  When I was on the Interagency Authority on Residential Facilities for Children, one of the other representatives was Lorrie Riggs who was then the head of Governor Edgar's Purchase of Care Review Board.  He basically was an employee of the State Board of Education and the ISBE Regulations governed the Illinois Revised Statutes having to do with the payment for, and rate setting,  for the residential facilities in the State.  Loree knew that I was a lawyer and one day he proudly showed me a 766 line statute that the Legislative Reference Bureau had helped the Board of Education draft. I think it was in the first reading.  After I read it I looked at him and said"  "Loree, you have 766 lines.  I think you could shorten it a bit."  He asked me how and I said, " Just say that education won't pay."   

3.  Policy in the Real World.   I started representing the Bank of Illinois in the mid 1970's when they had large floor plans and were the largest retail installment lender.  When people went bankrupt, many of them had car loans.  If they wanted to keep the car, there was a process by which they could reaffirm.  The other viable option was to surrender the car and discharge the debt.  Because cars decline in value rapidly, sometimes the car was worth less than the amount of the loan outstanding.  When I first started doing this,  the attorney would often call me up and say something to the effect that the car was worth only $3000, but they owed $4000,  their client was willing to keep the car if the Bank would renegotiate the loan.  Sound kind of familiar.   What I learned was that when you first started to renegotiate these loans, that you had to renegotiate every one of them.  Thus, what had first appeared to be a prudent business decision, was a bad long term policy decision.   It may have been good for me, but it was bad for the client.  I  suggested and the client adopted a policy that you had two choices, reaffirm or surrender.  This policy worked until the liberal bankrutpcy judges allowed these loans to be renegotiated by judicial fiat in a Chapter 13.  (This was changed, for the most part, in the new bankrutpcy legislation.)   My point here is that sometimes you have to take a macro rather than a micro approach to policy.  Although you may be able to micro manage more situations by more regulations,  the cost of more government involvement is not necessarily better.  My view is that the free market may not be perfect, but it is usally better than more government.