To be sure, Fisher never advocated the use of price/sales as a stand alone indicator of value. It is just one tool to use when in conjunction with other tools to estimate a company’s value. The PSR is particularly useful when looking at a company without earnings as the more commonly used P/E ratio is meaningless.

According to Fisher, the underlying strength of the PSR, when compared with the P/E ratio, is its consistency or predictability. Earnings can fluctuate widely as we know today. Sales, on the other hand, are more stable. Sales also have the advantage of being less likely to be manipulated. Earnings are, after all, estimates based on accounting assumptions. They fluctuate with one-time expenses, write-offs and short-term changes in margins.

Fisher has been a long time contributor to where he has advocated the use of the Price/Sales ratio. In a 1984 article in Forbes, Fisher provided an important and frequently overlooked modification to the PSR. In this article he introduced what he called the “Debt Adjustment Factor.” As the name implies, Fisher found it necessary to adjust the PSR to reflect both short term and long debt. His DAF can profoundly effect our understanding of the basic PSR. For illustration purposes, we can look at some companies in the aerospace industry and compare PSR’s with debt adjusted PSR’s:

Company PSR Debt Adjusted PSR
Alliant Techsystems (ATK) 0.62 1.93
Boeing (BA) 0.46 3.29
Ceradyne (CRDN) 0.84 0.30
Honywell Int’l (HON) 0.63 1.98
Locheed Martin (LMT) 0.75 15.00

Fisher developed a range of PSR values to measure a company’s popularity in the market. The ranges vary by size of company and between high margin businesses and companies operating industries with inherent thin margins such as supermarkets. Accordingly, small growth companies are unpopular if their PSR is under 0.75 and very popular when the PSR is over 3.00. Similarly, companies with multibillions in sales, such as LMT mentioned above, are unpopular when their PSR is below 0.20 and popular when they are over 0.80. Thin margin businesses are unpopular at the 0.03 level and popular at 0.12.

While the PSR is a key factor in Fisher’s approach, it is clearly not the only factor to consider. Terrible companies can have a low PSR simply because the market sometimes recognizes a badly run company. The other things we need to consider are profit margins, earnings growth and free cash flow.

There is any number of ways to determine if a company’s common shares are priced for positive future returns. Fisher offers us an insight to one such method.

Good Article? Pull it from here:
The Price Sales Ratio Revisited

In the world of finance we can innovate and change and find ways to get around regulation. This has been the modus operandi of the financial system during my entire professional career. Consequently, the financial system of today in substantially different than the financial world that existed in the 1960s. I have called the last fifty years or so the age of financial innovation. Regulation and oversight of the financial system does have to change. But, we need to be careful about the change in regulation and oversight that results and not just give in to populist calls to “put a stop to the greed on Wall Street”.

The characteristic about finance that fails to be taken into consideration when people believe that they can “control” finance is that finance is about nothing more than information. Finance is numbers, nothing more, and numbers can be packaged in any way that a person wants to package them. On our currency we read that “This note is legal tender for all debts, public and private.” That is, people and governments can pay you for things in this script and you must take it. And, what more is a check, or a bank deposit, or a bond, or a stock certificate? In most cases today, these are nothing but 0s and 1s in a computer system. Finance is nothing more than information and how information is handled and transformed.

The unique thing about information is that it spreads and, as we have found out historically, information cannot be contained. Of course, its spread can be postponed or stymied for a while, but eventually its spread takes place. All human history is a record of this fact.

We see this trend also works in non-financial areas. Information relating to modernity and science and democracy is spreading throughout the world. In some areas this spread is being resisted by some who are attempting to keep the world mired in the ideas of the 7th or 8th century (C. E.) This attempt to prevent the spread of the idea of the modern world has resulted in violence and tremendous pain to many. But, the spread continues. It has all through recorded history. In the end, the resisters cannot stop it and their efforts to slow it down do nothing but cause unhappiness and dislocation.

The financial system over the past 50 years or so has been an engine of new creations. In the 1960s, we saw the movement of banks from being asset managers to becoming liability managers through the creation of instruments like the negotiable certificate of deposit and Eurodollar accounts. This broke down the geographical limitations on banks and helped them continue to evade government rules and regulations. In the academic world increases in computing power combined with the vast amount of data available on the stock market allowed for the development of ideas relating to portfolio management and risk control, which culminated in the creation of CAPM and the efficient markets hypothesis. A third innovation related to the growth and development of venture capital that put money into the hands of more and more innovators starting up small businesses. All of these developments had to do with information and how that information was bundled and traded.

In the 1970s we saw the development of the mortgage backed security, the junk bond, and the leveraged buyout. The creation of the mortgage backed security by the federal government was the test case for “slicing and dicing” up cash flows into tranches that could be packaged in ways that met the specific needs of different investors. And, as they say, the rest is history.

The development of the junk bond? The legend is that Michael Milken, sequestered in the bowels of the Lippincott Library of the University of Pennsylvania discovered information about the performance of “fallen angels”. These were high quality bonds issued sometime in the late 1920s or early in the 1930s whose companies had had financial difficulties. The bonds fell out of favor and hence yielded very high returns. Milken discovered that because of the lack of interest in these securities their actual performance substantially exceeded the performance exhibited in their market pricing. This information, which was confirmed by more current information, led Milken to develop the junk bond, the first such issue coming to market in 1976.

In addition, fund managers arose, like KKR, which discovered information concerning the value of assets that were on the books of many corporations. Often, these assets were undervalued because they were recorded at historical values and were substantially below current market values. Previously, these companies were “out-of-reach” of corporate raiders, but with the creation of the junk bond, all companies in the United States came within the reach of well-funded organizations. So, finance could now reach the largest, as well as the smallest, businesses.

This evolution, of course, continued into the 2000s. The point is that as information becomes available it can be used in many different ways to serve many different purposes. “Slicing and dicing” the information known as cash flows is not new, but is a part of a process that has a long history. And, due to the nature of information this process is not going to go away.

The Obama administration is now making its attempt to re-regulate financial institutions and financial markets. The proposal offered yesterday is much watered-down from what the “more progressive” wing of the political spectrum had wanted: its thrust is not sufficiently “Rooseveltian”. Still others express concern that the administration is going too far in some areas.

My take on the Obama proposals for financial regulation: it will make little difference in the end. Obama needs to take some kind of action and look like he is attacking the problems faced by the society. In the longer run the new regulatory scheme will make very little difference.

Financial innovation is going to continue. If some efforts are constrained in the United States, they will pop up elsewhere in the world. The incentives to innovate are still there. If we force the innovation to go off-shore, then we are, in my mind, the losers. This innovation will help others but provide little benefit to us.

What is needed? To me the most important thing that is needed is openness and transparency. We need to know what is being done and by whom. As derivative securities and hedge funds grew and prospered, we heard over and over again that they could not tell anyone what they were doing because, if they did, the narrow spreads they were working with would go away. Well, guess what! Most everyone knew what deals were being struck and the spreads went away anyway. That is why these organizations needed to use more and more leverage to take on riskier and riskier deals.

Highly competitive markets where there are few if any barriers to entry cannot continually provide exceptional returns. “Trading” is not the source of sustainable competitive advantage and keeping things secret will not salvage trading schemes. Openness and transparency will result in financial institutions focusing on what really creates competitive advantage and what is sustainable. This is necessary for the existence of a strong and healthy financial system.

Secondly, we need methods to close or put-out-of-business in a more timely fashion financial institutions that are troubled or are insolvent. Re-instating and improving mark-to-market accounting is a must. Increased openness and transparency should help the market place carry out this function, but, the regulatory system needs to have more FDIC-type efficiency to move quickly into institutions and shut them down. (The Federal Reserve is not the institution to do this. It needs to keep its focus on the conduct of monetary policy.) Moving quickly to resolve problems has always been the best policy. Managing institutions based on wishful thinking, a major trait of the banking system, is not a good policy.

We need financial regulation and oversight, just as we need periodic checkups and advice from doctors. However, there is only so much that regulators can do. Unlike our physical systems, our financial systems are going to innovate and change. My guess is that in the future with the continued advancement of information technology financial innovation will continue to increase rapidly and will serve as the model for more and more of our non-financial markets. “Information markets” is the model for the future. This innovation will, in one way or another, get around whatever regulation that is imposed. That is why openness and transparency is so important. But, that is also why the system of failure and bankruptcy should be enhanced and enforced. These, to me, are the major requirements we should impose on the financial system.

Good Article? Pull it from here:
Financial Well-Being and Regulation: the Obama Effort

The high volatility in the financial markets has resulted from the high degree of uncertainty that plagues the market with regards to what is going to happen to the economy, the financial system and whether or not the programs initiated by the Obama administration will work. The stocks that have been moving the most have been those that have gotten a lot of publicity over the last six months or so and in which there is a lot of uncertainty connected with the unknown future of the companies they are associated with.

Niederauer goes on to say “large institutions and other long-term investors” have basically sat on the sidelines during this little run-up. The short-term traders do not need to take an extended view of prospects and therefore attempt to make money on the ups and downs of the market. Thus, it is hard to use the recent uptick in the stock market as a longer-term indicator of the economy with a lot of confidence at this point. He adds that when the large institutions and other long-term investors come back into the market the trading volumes will become larger and will be more consistently there.

And, why should the longer-term investors come back into the market at the present time. A piece of evidence against jumping in right now is the bankruptcy of mall owner General Growth Properties, Inc., which is recorded as one of the largest real-estate failures in the history of the United States. The cloud over the commercial real estate sector of the economy has been approaching for some time now and this news seems to be just the first of many that will follow.

Also, Capital One Financial, one of the largest issuers of credit cards in the United States, just announced writedowns that have exceeded the unemployment rate, an interesting relationship if you ask me. It seems like this is an indicator of how bad things are when credit card charge offs exceed the unemployment rate but I don’t see any necessary correlation between the two. Anyhow, the expectation is for credit charge write offs to continue to rise as home foreclosures and personal bankruptcies continue to rise indicating more pain in the future. Personal bankruptcies have risen almost to the pre-2005 level, the time when the bankruptcy laws changed.

In addition, although people keep contending that the housing market is getting firmer, housing starts continue to show a substantial weakness. Housing construction in March fell to an annual rate of 510,000 units, the second lowest level on record. This total was almost 50% below the level of starts attained in the same month last year.

Building permits also fell 9 percent from February to an annual rate of 513,000, which is down from 932,000 last year. This number provides some indication of the amount of future construction that will take place.

And, the amount of foreclosures on personal property continues to rise. It has been reported that foreclosure filings increased 9 percent in the first quarter of the year with filings rising 17 percent from February to March. The area of personal finance continues to be unsettled. And, this is not even considering the rising level of small business foreclosures that seem to be rising monthly.

There is little good news to encourage the large or longer-term investor coming from other areas in the financial sector. We still have to see the results of the “stress test” on the banking system. It seems that Secretary of the Treasury Tim Geithner has messed up another public relations opportunity, this time over the announcement of the results of the stress test or the fact that there will be no announcement of the results or that there will be a limited release of information. For an administration that supposedly was going to see to it that the government operated with more transparency and openness, the Treasury Department and its leader have certainly not contributed to the confidence that it is on top of the situation.

Then there is the concern that the banks have not reported accurately the value of their assets in order to obtain TARP funds. (See my post http://seekingalpha.com/article/130712-are-the-banks-telling-us-the-truth.) There is seemingly no reason why we, or anybody, should take seriously the financial reports coming out of the banking system, including the quarterly reports being released this week by major financial institutions!

We further read that “Fitch Ratings is warning investors in complex loan investment funds about the practice by their managers of accounting for loans at par, regardless of market value of the loan.” (See “Fitch alert on accounting for CLOs”, http://www.ft.com/cms/s/0/cb8f70ac-29e7-11de-9e56-00144feabdc0.html.) Fitch is concerned that managers are attempting to get around rules on how they account for collateralized loan obligations (CLOs) by encouraging investors to consent on having certain restrictions removed so that they can mark assets up to par. In early March, Moody’s warned the market that there would be a review of ratings in response to changes in its rating assumption, including an increase in expectations of the default rate among leveraged loans. In February, Standard & Poor’s warned investors that the debt issued by CLOs could be at greater risk of losses than they realize if only a few companies default.

And, there is more!

The problem is that there is too much debt around. Debt loads have to be worked off and in some way reduced. Of course, one way to reduce debt loads is to inflate away the real value of the debt which is what Bernanke and the Obama administration are trying to do. Otherwise, debt has to either be paid down or written down as Capital One is doing.

A helpful suggestion for government action is to provide money to write down the principal of mortgage loans rather than help troubled mortgagees to get interest rates on the loans reduced. This would have a more stunning effect on home owner performance than would trying to put people to work or to reduce interest rates or to inflate away the debt. It would also probably be cheaper. Pouring money into the banks has not worked! Why not try something else to reduce the debt problem?

Whatever is done, time is going to have to pass. Large investors and longer-term investors will not come back into the stock market until they see that the debt issue is passing and that people, consumers, have their balance sheets more in control. Until then, the stock market will just be a traders’ market. So don’t trust market swings one way or another. Focus on what the real problem is.

Good Article? Pull it from here:
Be Careful What Bandwagon You Jump Onto

“The hope is that as the banking system works through its problems, TARP funds will be returned and the mortgage-backed securities will mature or be sold back into the market allowing the balance sheet of the Federal Reserve to contract back to where it was in the summer of 2008. The banking system is apparently holding onto reserves to protect itself and that is why they are really not lending. The idea is that if they don’t need these excess reserves they will return them. This is what the Federal Reserve is planning to happen. Let’s hope that they are correct!”

On this issue, let me point out the post by Jonathan Weil on Bloomberg this morning, “Crisis Won’t End Until Balance Sheets Get Real” (http://www.bloomberg.com/apps/news?pid=20601039&sid=azsX7o.atu7U). After presenting interesting data on the state of commercial bank balance sheets he argues the following:

“Banks and insurers got Congress to browbeat the Financial Accounting Standards Board into making rule changes that will let them plump earnings and regulatory capital. There also was Fed Chairman Ben Bernanke’s line in March about “green shoots,” which sparked a media epidemic of alleged sightings.

For all this, we still have hundreds of financial companies trading as though the worst of their losses are still to come. Just imagine what their prognosis might be if the government hadn’t pulled out all the stops.”

And, then Weil closes:

“Truth is, there’s no way to know if the economy has turned the corner, or if last quarter’s market rally will prove sustainable. Yet when this many banks still have balance sheets that defy belief, it means the industry probably hasn’t re- established trust with the investing public.

Trust, you may recall, is the financial system’s most precious asset. On that score, we still have a long way to go before we can say this banking crisis is over.”

This is the short run problem and it is the one that is going to determine whether or not the Federal Reserve is going to be able to shrink its balance sheet. This has been the point of my last two posts. And why are we facing such uncertainty at this point? Because the Mark-to-Market rule was pulled and because there is not enough openness and transparency in the public financial reporting of financial institutions. If there are going to be regulatory changes in the future, a lot is going to have to be changed as far as the reporting requirements for financial institutions is concerned.

But, this is just the short run problem.

The longer run problem is the projected budget deficits of the Federal government. Even if things work out as the Federal Reserve has planned as far as bank reserves are concerned and Federal Reserve credit retreats back to where it was in August 2008, there is the massive problem facing the country about how prospective government deficits are going to be financed. The bet is that the Fed will finance a substantial portion of the deficits to come. Let the printing presses roll!

The fear? Inflation.

But many say, we are in a severe economic contraction now. The fear should be deflation and not inflation.

The only response to this counter argument is that in the latter half of the 20th century, any nation that has run substantial deficits has, sooner or later, run into problems related to inflation. Monetary authorities are never so independent of their central governments that imprudent fiscal policies are not in one way or another underwritten through some form of monetization. And, since this happens time after time, how can the international investing community sit on the sidelines and do nothing? Yes, the United States is in a severe recession right now, but what are your odds for the monetization of a lot of the Federal debt over the next three years? Over the next five years? Over the next ten years?

Where do you look for such for an indication of market sentiment on this? Look at the value of the United States dollar. The dollar fell by about 15% against major currencies in the latter part of the 1970s as the Carter budget deficits seemed to get out-of-hand. As we know, Paul Volker played the savior there by conducting a very restrictive monetary policy to bring the value of the dollar back in line. However, the Reagan budgets became so severe by 1985 that the value of the dollar began to plummet. In the face of continuing deficits and the realization that this would continue to result in a weak dollar, Volker gave up the reins of the Federal Reserve in August 1987. The dollar did not pick up strength again until fiscal restraint was returned to Washington with the Clinton administration as the value of the dollar rose over 25% from April 1995 until the end of 2000. The massive budget deficits of Bush 43 were translated into another precipitous decline in the value of the dollar which fell by almost 40% between the middle of 2002 to March 2008.

The fiscal policy of a nation does matter to the international investment community!

But, you say, look at all the other major countries having economic problems and their budgets are out of balance as well. Look at England, Germany, Italy, France, and others.

The response to this? This is not the case for many of the major emerging countries of the world, specifically the BRIC countries. Perhaps one leaves Russia out of this, but China, India, and Brazil are going to emerge from this period much stronger relative to the United States than could have been thought even a year ago or so. So is Canada and several other important countries. This world crisis is going to shift world economic power in a way that has not been seen since the shifts in world power that took place in the 1920s and 1930s. And, international investors are realizing this!

Yes, the dollar will still be used as the reserve currency of the world…for a while longer. The Chinese, and the Russians, and the Brazilians, and the Indians all realize this. And, even though they keep talking about establishing a new reserve currency, they seem to back off and say that the dollar cannot be replaced right now. Yet, the Chinese have called for the Group of 8 to talk about a new reserve currency at its upcoming meeting. The issue IS on the table and my guess is that it is not going to go away.

Which brings me back to the deficits. In my mind, the budget deficits of the United States government are out-of-control right now and there is great concern that this administration will not be able to regain control of them in the near future. There is no “reversal” mechanism that is built into these budgets as the Fed has attempted to build in a “reversal” mechanism in its efforts. As a consequence, great pressure will be put on the monetary authorities over the next several years to monetize a substantial portion of the debt that will be created. The history of the past fifty years or so is that the Fed will not be able to avoid the pressure. This is perception that the international investing community will be bringing to the market when it place its bets. This can be translated into higher long term interest rates in the United States and a continuation in the decline in the value of the United States dollar.

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Is Treasury’s TARP Debt Already Monetized? Part III

When financial institutions securitize assets and elect off balance sheet accounting treatment they are pretending that neither their securitized assets nor their related secured debt exists. Like a deadbeat dad denying paternity, securitization accounting is designed to avoid admitting responsibility by securitization sponsors.

Most securitizations are a form of secured borrowing executed by banks and other financial institutions. However, “form over substance” securitization accounting encourages securitization sponsors to act as if secured borrowings are really asset sales and thereby decrease the reporting of both their asset size as well as their debt.

When institutions use off balance sheet accounting for secured debt transactions financial ratios are distorted, and transparency is destroyed. No one can tell if securitizing institutions are well capitalized or not and whether their operating performance is consistent given the scope of their operations.

As a result of securitization accounting financial institutions like Bear Stearns, Lehman Brother, Citigroup [C: 3.97, -0.21 (-5.02%)] and Merrill Lynch appeared much less leveraged, and much more profitable, than they really were. The “granddaddy” of securitization shops, Citigroup, at one time had more than $1 trillion of assets that it reported as “off balance sheet”.  Citigroup pretended that the $1 trillion of off balance sheet assets were orphans; they just appeared one day on Citigroup’s doorstep.  Simple financial measures such as net interest spread and asset quality and profitability ratios were vastly distorted by Citigroup’s orphans.

The securitization accounting rules also facilitated the “originate for sale” shadow banking system that lead to sub-prime and other consumer and commercial lending abuses.

The new securitization accounting rules are supposed to enhance transparency and make it much tougher for financial institutions to pretend that they don’t own their assets. But, no one is really sure how the changes will play out in the real world marketplace. The new rules may enhance transparency.  On the other hand, mechanical application of new and complicated rules may confuse already incomprehensible reporting. Retro-active application of the rules may highlight how dangerously undercapitalized some financial institutions remain and may spark a new round of loss of confidence. Simplifying the rules may help restart the securitization marketplace and help the economy, but then again they may be another nail in the capital markets coffin.

I don’t know what this all means because I never understood the old rules and don’t know what the new rules will do to financial reporting. There is a Wall Street sub-culture that holds itself out to be “securitization accounting” experts. Personally, I never bought the “snake oil” that these guys were selling. I don’t think that the so called experts have a clue what is going to happen when the new rules are enacted and if they don’t know the media certainly has no clue which is why there hasn’t been much reporting of this accounting change.

It’s a good idea to fix securitization accounting rules and I support the effort; just not the way that reform is playing itself out. In fact on December 4, 2008, I wrote a letter to then President Elect Obama suggesting that reforming securitization accounting needs to be a cornerstone of financial institutions reform. The following is from my December 4^th letter:

If accounting rules matter, bad regulatory accounting rules matter even more. About 20 years ago bad regulatory accounting rules were enacted that apply to all banks and have the unintended side effect of encouraging the worst excesses of the securitization market. These rules reward banks that use the OPM model (i.e., “other people’s money”) to finance assets and penalizes banks that want to create well capitalized investment structures. These bank regulatory rules virtually mandate the “originate and sell” model of finance and need to be fixed immediately. Generally accepted accounting practices have run amok trying to work around the bad bank regulatory rules. The accounting industry is about to “reform” the rules relating to securitization accounting in FAS rule 140 but the new rules continue to make a mess of things. An interagency initiative is needed to fix this mess. And, interagency cooperation will only happen with Presidential leadership.

The problem with the current securitization accounting reform initiative is that it isn’t interagency reform but rather unilateral work of the Financial Accounting Standards Board which has at best mixed motivations. Until securitization reform is a joint effort of all constituencies that are affected it won’t work.

The U.S. needs a joint task force to address this issue including the SEC, OCC, FDIC, Federal Reserve and state insurance commissioners. Regulatory and statutory accounting rules must be conformed to financial accounting and disclosure. Securitization reform is needed but ad hoc and piecemeal reform is probably worse than no reform and what we are getting is ad hoc reform.

-Mark Sunshine

Disclosure: This article is taken from the website Sunshine Notes with the permission of the original author.  All questions regarding disclosure should be referred to the original author.

Background

Since 2005, the convergence to IFRS was apparent with the European Union requiring companies listed on the EU regulated stock exchanges to file consolidated statements using IFRS.  The SEC responded to this in 2007, agreeing to accept these IFRS statements from the foreign issuers without forcing reconciliation to GAAP.  This proved the SEC’s acceptance and belief that the international standards were in fact high quality.  Throughout this time, strong debate evolved regarding the United States adopting IFRS.  FASB and IASB were working together, and in September of last year, they both reaffirmed their commitment to converge all major accounting standards by 2011, the year in which every capital market except the US will be using IFRS as a basis for financial reporting.  The SEC again came into play just recently, proposing a roadmap for IFRS adoption that concludes with a 2011 decision on whether the international standards will become mandatory for all US issuers.

SEC’s proposed roadmap consisted of a timeline towards a mandatory conversion in FY 2014, with companies being able to voluntary convert as soon as this FY 2009.  Regardless of when they choose to make the switch, they must begin their IFRS reporting in the annual 10-k, where they must file audited IFRS statements for the year of adoption and the two preceding years.  For example, a company that decides to wait until the mandatory conversion at the beginning of FY 2014 must file their 2012 and 2013 statements under IFRS as well as 2014.

While there are many similarities, there are also quite distinct differences between US GAAP and IFRS that need to be illustrated.  Of utmost importance, GAAP standards are highly rules-based, consisting of over 17,000 pages of detailed guidance.  IFRS, however, is much more principles-based with its 2,500 pages, requiring the managers to exercise much more judgment in their valuations.  For example, revenue recognition is one of the most complex elements of GAAP accounting due to its comprehensive guidance on industries and different types of contracts.  Under IFRS, revenue recognition is based on a single standard with general principles applicable to different transactions. The reasoning behind this is put forth by Tom Jones, Vice Chairman of the International Accounting Standards Board (IASB) that develops IFRS.  He responds to criticisms on the lack of rules by claiming, “When you write rules, smart people can get around them.”

The debate has been intense regarding whether the SEC will mandate a complete switch to IFRS or a convergence between IFRS and GAAP.  Recent evidence leads to the belief that the adopted IFRS will be more of a convergence.  A few weeks ago FASB changed its GAAP guidelines on fair value measurements and mark-to-market accounting.

As a result, EU banks under IFRS have been expressing concern that the US banks have an advantage.  The IASB is expected to issue guidance on the subject that is very similar to FASB’s, showing agreement between the two boards and a converging of GAAP with IFRS.  Public comments to the proposed roadmap show the agreement among companies that negotiations like these need to happen to lessen the cost of adoption, a prominent concern regarding the switch.  At this point in time, the IFRS still needs development, but once the certain areas the SEC deems weak are taken care of (ex; accounting insurance contracts), the standards will be ready for adoption.

It Will Happen Before You Know It

Although SEC Chair Mary Schapiro has stated that a transition to IFRS in the United States “will take a back burner” due to the overhaul of the regulatory system, the rebound of the global economy needs to bring with it a global accounting standard.  With Brazil, Canada, Chile, India, China, Japan, and Korea all committed to adopting IFRS, as well as the current EU members already under the standards, IASB member John Smith recently told a European audience that “it is in the interest of the United States to adopt IFRS in the next five years,” and that the “cost to the US of failing to adopt will be high.”  This makes sense, considering the fact that if every other country in the world is using the international standards, how would the US maintain credibility in the accounting realm?  With the inevitable trend towards globalization that has been hitting the economy, not adopting IFRS would weaken American companies’ strength in the global capital markets.

Committees and groups are in place to make the convergence happen in the most efficient way possible.  The Financial Crisis Advisory Group (FCAG) was established by FASB and the IASB to give guidance to the two boards about the implications of the global recession and the changes that may need to be made as a result.  Their job is to recognize where reform needs to be made and ensure the proper improvements are enforced.  The FCAG fully supports IFRS, and have written letters to the G-20 summits expressing the urgency.  The topic made it into the G-20 discussions in London, with the world leaders conveying that a global standard needs to happen.

Why It Matters to Investors

Throughout the next few years, companies will be making the steps towards filing their statements under IFRS.  Certain aspects of the statements will change.  Revenue recognition will be different, along with specific standards regarding pensions, leases, loan provisions, and many other items.  To give an example, under US GAAP an operating lease must be expensed through the income statement and cannot be recognized on the balance sheet, thereby reporting lower earnings.  Under IFRS, an operating lease need not be expensed as it may be held by a lessee as an investment property if certain conditions are met.  It is specific differences like these, as well as the extra judgment that comes along with a principles-based system, that has resulted in companies under IFRS often not reporting higher earnings.  Additional expenses, however, will definitely occur.  When the EU companies in 2005 made the switch from local GAAP to IFRS, the Institute of Chartered Accountants in England and Wales estimate that European companies spent about .05% of revenues in the first year on making the switch.  Performance based compensations and dividends will be affected.  The entire education process will need to be changed, all the way from accounting students to senior executives (under Sarbanes-Oxley the CEO and CFO must attest for the accuracy of the statements).  Each statement will be affected, and investors need to stay aware and educated about the implications.

What Investors Need To Do

Stay in tune with FASB and IASB’s agenda to be up to date on what is happening next.  Understand the differences between US GAAP and IFRS and their impacts on financial reporting.  Make sure to read through the full disclosures, as a move from a rules-based system to a principles-based system will result in more detailed footnotes.  By staying educated and knowledgeable of what is happening in the accounting world, when the time comes investors will be able to focus on the company’s operations instead of the change in accounting standards.

-Phillip J. Harper

Disclosure:  None

Values will be based on what the assets would sell in an “orderly” transaction in a non-distressed environment.  This may turn out to be quite dangerous, as the banks are now able to give a market value for toxic assets with no actual market. Banks are now also able to only have to write down part of their impairments if they plan on holding the asset to maturity. In the traditional mark to market rules, an asset that suffers an impairment would have to be written off completely, accounting for the write-down as a realized loss. With the loosening of rules by FASB, assets will only have to be partly written off due to impairment. This does not show the true value of the asset, resulting in less transparency within the balance sheet.  Anyone who follows the markets knows that losses have occurred, and knows the “garbage” is still on the balance sheet, hidden or not.  This will ruin the confidence investors have in their assessments of the risks involved in a bank.  With the banks able to hide these markdowns, how can we have the trust to buy?

Auditors’ Reactions

It will be interesting to see how auditors portray the new standards, especially since there was a strong opinion among financial reporting directors that auditors took fair value accounting too far, forcing firms to provide proofs that the assets were indeed valued fairly.  Auditors are known to be very conservative in their opinions of the financial statements of a company to prevent lawsuits or damages to their own reputation.  That being said, the accounting changes are another way for banks to paint a better condition of their statements.  Auditors will be stricter regarding their valuations, especially since the split in losses will be difficult to verify.  More experience is necessary for auditors to feel comfortable signing off on the banks’ valuations using the new standards, leading to the possibility of some banks still using fair value accounting to avoid complications.

Going Forward

Going forward, it is tough to say how the accounting changes will effect the capital markets.  With the common belief that reactions due to speculation were reflected in the markets before any changes were even made, there may not be an impact at all.  Many say confidence will be restored in the markets, since investors know banks will be able to almost “hide” losses using their own valuation models.  Also, even though an impairment occurred, firms will not be forced to write off the entire impairment, so the balance sheet won’t be hit nearly as hard. The true health of the firm will not be accurately shown, leading to much less transparency within the statements. This is surprising, since the recent goals of the FASB has been the push for more transparency. To big bankers, it’s exactly what they’ve been pushing for, as banks will be able to recover billions of dollars in losses. So far, Wall Street has reacted favorably to the new standards, with analysts predicting that some banks will increase quarterly earnings by up to 20 cents.  However, it has become all too familiar to see firms valuing assets above their true market value. This may in fact prove to be the completely wrong move by FASB.

What To Look For

Look for second quarter earnings to reflect these changes.  Expect big banks to report higher earnings as a result, while other banks stick to the traditional mark to market rules, and possibly suffer from the disadvantage.  For global multinationals, the convergence of US GAAP and IFRS will definitely have an impact on the long run, as the IASB is considering also loosening it’s mark to market and impairment standards. If this does in fact happen, global markets will most likely react just like the US markets have, and will cause these standards to be a permanent fixture in the balance sheet. Other countries’ standards outside the IFRS are also considering following suit. Canadian banks are pushing for the adoption of the U.S. mark to market rules, so as to not have a disadvantage in the North American capital markets.  The global recession has forced the notion that all countries should be under the same accounting standards (IFRS), so it is necessary for the IASB and FASB to agree, and have a joint approach regarding the financial crisis.  This will prove to be a prominent evolution in accounting, especially after the G20’s call for the reduction in the complexity of the financial instrument accounting.  Immediately after FASB announced the changes in early April, IASB began a 30-day discussion process to ensure the meeting of the urgent demands of the issue.  IASB meets April 20-24, so look for changes to IFRS that will impact the global markets in a similar manner to FASB’s impact on the US markets.

-Phillip Harper

Disclosure: None