Peeling away financial reporting issues one layer at a time

SFAS 157: Is the Government a “Market Participant”?

Last Thursday, a new reader (who prefers to remain anonymous) wrote:

"Have you considered addressing the hotly debated issue of how assets sold into the TARP [Troubled Asset Relief Program] will be accounted for by banks, and whether the prices [offered by the government] should be considered market prices for other banks to use in valuing their holdings?"

What an interesting question!  The events of the last couple of days indicate that the U. S. government, prodded by Europe, is moving to a strategy of buying equity (non-voting, preferred).  But, the NYT reports that Treasury Secretary Paulson still wants to go forward with his plan to spend hundreds of billions of dollars on junk assets.  

Uncovering Yet Another Loophole in SFAS 157: What Else Can you Expect from a Rules-Based Standard?

The TARP accounting debate centers around a choice among two treatments: (1) purhcases/offers by the government are not relevant for valuation of unsold loans; or (2) it is appropriate to use the pricing information from government purchases to measure the fair value of unsold loans.

It seems that the debate exists because a reading of SFAS 157 indicates that both alternatives are within the rules; paragraph 11 of SFAS 157 states as follows:

"The fair value of the asset or liability shall be determined based on the assumptions that market participants would use in pricing the asset or liability. In developing those assumptions, the reporting entity need not [but presumably may] identify specific market participants." (my additional language is in brackets)

Whaddya know, another loophole for banks to dive through in this rules-based standard: the "need not" escape clause. The banks would prefer that the government should be considered a "market participant", while others may see the government as merely a safety net.

Treasury Secretary Paulson, would doubtless chafe at the suggestion that the government's 'bid' offers would be anything less than legitimate value-based propositions; and as such, a cure for our economic woes would be had. But, the stock market's negative reaction to his plan, and subsequent partial recovery after it was modified, may refute anything but the notion that Paulson's brainchild would only serve to re-fill the pockets of the Wall Street types that got us into this mess in the first place.

Whatever the view, the clear implication is that SFAS 157 did not anticipate these circumstances; and yet another 'interpretation' is about to be thrown onto the woodpile to keep the fair value light burning bright.

A Principles-Based Solution

This may be one of the clearest and cleanest case I have found in the realm of financial instruments to demonstrate that replacement cost accounting (entry prices) is principles-based; and fair value accounting (exit prices) is rules-based.

Imagine, if you will, that U.S. GAAP requires financial instruments to be measured at the 'ask' price (entry price) as opposed to the 'bid' price. A requirement to measure the toxic loans at replacement cost ('ask' price) takes TARP right out of the picture; because the government will not be indicating a price at which it would be willing to sell toxic loans — just to buy them.

Thus, the accounting procedure that follows from the replacement cost principle is simple and straightforward: a gain (or markup to the asset valuation) may be recognized only under two circumstances: (1) replacement cost of the asset increased; or (2) it was sold for an amount higher than current replacement cost. Whether the government is a "market participant," whatever that is supposed to mean in SFAS 157, is a non-issue.

In contrast, who can tell what the proper answer should be under SFAS 157? I sure can't, and that's the main lesson of this case. When policy makers get arround to providing its 'authoritative interpretation,' hard experience should inform us of the real principle at work: which interest group has the biggest checkbook.

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