Ugh, you say, accounting: bean counters and all that. Boring. That’s what I thought too, during my early adulthood, before taking some classes and learning how creative accounting can be.
And dangerous too. I can tell you some stories about bad accounting being bad business. In fact, I will, and on this blog. But first, this note.
Jason Mendelson titled his guest post on VentureBeat: FAS 157 is stupid:
Simply put, FAS 157 says that one must value investments at “fair market value.”
I object because it’s not possible to “fairly value” a private, early-stage portfolio the way that FAS 157 wants us to. This process injects a ton of false precision and costs and benefits neither the venture firm, nor its investors.
Prior to FAS 157, we would carry our investments at cost until such time that the company was: A) funded by a third-party and marked to the new cost; B) funded by insiders and marked down if the valuation decreased; or C) marked down due to poor performance. In none of these cases could I, at my own discretion, mark up one of my investments. Also, this was primarily a market driven approach, whereby we let the private funding market determine the value of the investment.
I’m just hoping Jason’s misinterpreting, because that sounds disastrous. But no, apparently not. FAS (sometimes called FASB, Financial Accounting Standards Board) apparently finalized this rule in 2007 and decreed it in effect last November. And poking around the Web, I find, to my dismay, a lot of people interpreting this like Jason does. Including the New York Times, CFO.com, and a lot of others. This is bad news.
So here’s a case that comes up all the time in business planning; it’s a common question I get from readers and customers: “How do I get my financials to show the real value of my business?” That comes with the explanation that some land or building or widget the person owns is “really” worth way more than what they paid for it. So the books are off. They say.
And every time I get those questions, or at least until this FAS 157 problem, I’ve been very comfortable answering:
“No, you don’t change that. There needs to be a backbone to financials. Things are worth what you paid for them, not what you think you can get for them. Tell your people that your business is worth more than its book value, and that’s fine; many businesses are. But don’t change your books.”
And I hope you can see why, particularly these days, when a lot of assets are worth less than we thought. Sticking to actual transactions, recorded amounts, makes so much sense. Your land and buildings stay on your books at the value you paid for them. Period. They are not worth more until you sell them, and, at that point, you get the profit.
Can you see the wisdom in that? Anchoring the financials to actual transactions? Because if people start revaluing assets willy-nilly, then all kinds of bad things happen:
- Do they pay taxes on the profits that appear like magic when an asset’s book value increases?
- How does anybody read a balance sheet? Do you discount for the optimism of the accountant who determined the “fair market value?”
- And the most unbreakable, revered rule in accounting, capital equals assets less liabilities, is suddenly all puffy and fuzzy; because now the assets’ worth are based on some subjective guess.
I’m sorry, but that sounds really bad to me.
I hope that this new rule will be applied reasonably. There is still that hope. I could see how “fair market value” could really be as simple as “when there’s been a transaction, reflect that in the value so your reporting to your stockholders is accurate.” So then it might apply to assets that have a legitimate easy measure of fair market value, like publicly traded stocks. But even there, those assets change every day; do we really want our company books to go up and down like the Dow Jones Industrials?
So I hope Jason’s wrong. But I looked at his bio. Seems like he knows his stuff.
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Comments
I think the FASB rule is the direct consequence of the banking crisis, and the degree to which financial institutions were able to conceal their distress by refusing to write down assets that were clearly devalued by market events – financial instruments purchased from an institution that is itself bankrupt.
A good idea. But I agree that the standard should not apply automatically to small businesses, or to assets in which no specific devaluation event has occurred.
I agree, accounting is an interesting world. I just usually leave it up to the professionals. Thanks for the post.
True enough. And that is what the banks are faced with, this constant "mark to market" rules. Problem is for the banks, there is no market to sell bad loans so the prices are very low.
On the flip side of the coin are real estate companies who have bought land at high prices and that land is now worth 10% what they paid. Because that land is considered inventory, they CANNOT re-value it until they sell it. So they paid very high taxes in 2003-2006 for profits they made, reinvesting those profits into more expensive land, and now they can't get a carry-back tax advantage until they sell the property. Many are doing so at very distressed prices just to get the tax benefit.
So investment firms invest in companies, banks invest in loans, but real estate development companies don't invest, they accumulate inventory.