Mark-to-Market Accounting and Investors Due Diligence

February 11, 2009

There is a rant in today’s FT by Willem Buiter on Barclay’s Annual Results reported in FT and he picks up a specific quote

“The bank confirmed it had written down its exposures to complex debt instruments by £8bn in 2008, though the impact was reduced by a £1.66bn gain it booked from the reduced value of its own debt.”

He writes

With very few exceptions, banks now use every means at their disposal to hide financial embarrassments on of off the balance sheet for as long as possible.  Rigorous mark-to-market valuation without managerial discretion as to whether to shift assets from one valuation bucket to another is a partial solution.  Unfortunately, the IASB lost first its nerve and then the plot in response to pressure from those exposed to toxic and dodgy assets.  Banks can now drive a coach and horses through fair value principles and release what information they want when they want it.

This approach seems to be a classic case of shooting the messenger. MTM is not to blame for the losses the shareholders are making. The gains being counted are perfectly legitimate for accounting and tax regulatory reasons.

The Annual Report clearly states that there is a gain of 1.66 billion from reduced value of own debt. They have not tried to hide it. All businesses have areas where a gain or loss happens not because of business operations but rather because of a change in external environment. Like Airlines losing due to sudden spike in Oil prices, Indian Exporters gaining from weakening of the Rupee Vs. the dollar.

The responsibility of the business and the auditor is to clearly highlight that there have been extraordinary gains or losses made from events outside the normal scope of business operations.

Of course in case of FI whose profits are primarily based on proprietary trading sorting out ordinary from extra-ordinary events becomes difficult, but again it’s the responsibility of the investor to appropriately discount the profits. Instead of having a P/E ratio of 30 he may decide to forgo investing in such risky investments.

As they say caveat emptor!