These matters face a crisis because of the mess in the financial markets. Fannie Mae and Freddie Mac are essentially bankrupt except for the intervention of Uncle Sam. Unless they receive federal handouts, they will go under because neither of them has the capital to survive. Banks are also facing tough times, as evidenced by the recent shuttering of IndyMac, and before it, New Century. Many banks are losing money because of the subprime catastrophe and also face shortages of capital.
Perhaps we should allow Fannie Mae and Freddie Mac to rest in peace. While Congress had good intentions when establishing these organizations, they forgot that there is no such thing as a free lunch. Since value equals the sum of the future cash flows, discounted at an appropriate rate, the Congress should have realized that when it lowered interest rates for marginal borrowers, it was simultaneously increasing home prices. One wonders what the net impact has been on these marginal home buyers.
Additionally, Congress did not know how to rein in greedy executives at Fannie Mae and Freddie Mac. These managers consumed many of the resources of these institutions via humongous salaries, stock options, and the consumption of perquisites. The managers even engaged in accounting frauds to maximize their exploitation of these assets. Maybe if they give back all of their ill-gained fortunes, the problems at these corporations wouldn't be so bad.
We all know that banks got in trouble with the subprime loans. Missal's bankruptcy court report discusses the culture behind the subprime market, the process, and the participants, including the moral hazard problem created by passing the risk to the next party, the greed and possible fraud by bank executives, the lax bank oversight, and the possible shoddy audits. More banks might fail because of the huge losses and the erosion of capital reserves.
Three accounting issues intersect with the woes of these financial institutions. They are the accounting for fair value, special purpose entities, and comprehensive income.
Many commentators have blamed the FASB and its promotion of fair value for causing the collapse of the financial market. This claim is absurd. The managers, through their incompetence and their greed and possibly their fraud, acted in an imprudent manner. Their ill-conceived decisions have led to these ruinous consequences. The FASB's requirement to employ fair values simply reports the economic truth. As such, the FASB needs to stand firm and maintain its adoption of fair value accounting, especially for financial instruments.
Feeble rules pertaining to special purpose entities helped Enron carry out its accounting fraud. The FASB desired to close this huge loophole, but the banking industry and even the bank regulators fought hard to prevent any meaningful change. The FASB issued FAS 140 and invented qualified special purpose entities; however, the accounting was easily subverted to keep many financial instruments off the balance sheet. The FASB has announced that it is considering the elimination of these games, thus requiring banks to report various securitized loans on the balance sheet. I suspect that the bank industry and the Fed will fight against this proposal. The FASB must remain resolute. It is a matter of reporting economic truth.
A number of items are found in a strange account titled other comprehensive income, such as gains or losses on available for sale securities, gains and losses on cash flow hedges, and foreign currency translation gains and losses. I believe that the capital markets are viewing these items as part of income, and accordingly bidding down the prices of bank stocks. Since the capital markets views these items as part of the income statement, surely the FASB need not conceal these gains and losses any more. It should repeal comprehensive income and force firms to recognize these gains and losses on their income statements. Inform everybody about the economic reality of these items.
The FASB must promote accounting truth. To do so, it must use fair values wherever possible, it must eliminate the off-balance sheet status of securitizations, and it must move the items found in comprehensive income to the income statement. The FASB will receive much political pressure from Washington, but it must have the fortitude to hold its positions. While the FASB cannot combat accounting fraud, it can at least indicate what the managers should have done by focusing on the substance of transactions and reporting them completely and without bias.
Relevant SEC and Bankruptcy Court Examiner documents:
This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.
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J. EDWARD KETZ is accounting professor at The Pennsylvania State University. Dr. Ketz's teaching and research interests focus on financial accounting, accounting information systems, and accounting ethics. He is the author of Hidden Financial Risk, which explores the causes of recent accounting scandals. He also has edited Accounting Ethics, a four-volume set that explores ethical thought in accounting since the Great Depression and across several countries. He is the co-author of a monograph, Fair Value Measurements: Valuation Principles and Auditing Techniques (with Mark Zyla, Managing Director, Acuitas, Inc.) to be published by BNA.2008 SmartPros Ltd. All Rights Reserved. Editorial and opinion content does not represent the opinions or beliefs of SmartPros Ltd.