This post first appeared on August 23, 2007
Part of the hangover that followed the dot-com bubble was rampant accounting fraud. Before then, accounting chicanery was virtually unheard of in Fortune 500 companies. It instead cropped up at high fliers with loose controls and/or overly aggressive cultures (remember Zzzz Best? Miniscribe?).
But in 2002, it seemed endemic, and for the first time, involved a large number of respected companies, such as Bristol Myers, Freddie Mac, Lucent, Merck, and the grandaddy of the once mighty, now fallen, Enron.
Large scale accounting fraud at large corporations generally required the help, or at least the acquiescence, of their external auditors. That in turn did considerable damage to the industry’s reputation and its partners’ net worths.
So in the interest of client empowerment, and out of the recognition that the Big now Four can’t afford to get any smaller, the Financial Accounting Standards Board approved new rules last September to enable corporations to engage in fraudulent, um, creative accounting all on their own. And since these new, um, creative practices are all in conformity with FASB, no one will get in trouble.
Now I am sure some readers think I have gone completely off the deep end and am making this up, or at least exaggerating. But a Bloomberg story (hat tip Michael Panzner) tells us that Wells Fargo used something called “Level 3 gains” to create $1.21 billion of pretax income last quarter out of thin air. Without this fantasy income, Wells would have shown a year-to-year decline.
This Bloomberg story goes into considerable detail about exactly what Wells did; here’s the outline of what allowed them to be so, um, creative:
So what are Level 3 gains? Pretty much whatever companies want them to be.
You can thank the Financial Accounting Standards Board for this. The board last September approved a new, three-level hierarchy for measuring “fair values” of assets and liabilities, under a pronouncement called FASB Statement No. 157, which Wells Fargo adopted in January.
Level 1 means the values come from quoted prices in active markets. The balance-sheet changes then pass through the income statement each quarter as gains or losses. Call this mark-to- market.
Level 2 values are measured using “observable inputs,” such as recent transaction prices for similar items, where market quotes aren’t available. Call this mark-to-model.
Then there’s Level 3. Under Statement 157, this means fair value is measured using “unobservable inputs.” While companies can’t actually see the changes in the fair values of their assets and liabilities, they’re allowed to book them through earnings anyway, based on their own subjective assumptions. Call this mark-to-make-believe.
“If you see a big chunk of earnings coming from revaluations involving Level 3 inputs, your antennae should go up,” says Jack Ciesielski, publisher of the Analyst’s Accounting Observer research service in Baltimore. “It’s akin to voodoo.”
We are likely to be entering another post-bubble period of weak earnings, so Level 3 earnings and other, um, creative accounting practices are likely to become popular. Investors beware.
3 comments
Comments are closed.
“…the Financial Accounting Standards Board approved new rules last September to enable corporations to engage in fraudulent, um, creative accounting all on their own. And since these new, um, creative practices are all in conformity with FASB, no one will get in trouble.”
“You can thank the Financial Accounting Standards Board for this. The board last September approved a new, three-level hierarchy for measuring “fair values” of assets and liabilities, under a pronouncement called FASB Statement No. 157, which Wells Fargo adopted in January.”
Actually, the issuance of SFAS 157 was a positive move. To be precise, this pronouncement did not expand the range of options available to financial statement issuers for valuing assets or liabilities. The intent of 157 was to provide clarity. It provided further guidance on how to define fair value. It also provided guidance on the relevant market to be referenced when making price comparisons during the valuation process, among other things. Most importantly, it required issuers to identify and disclose, according to a three level hierarchy, the inputs (observable & unobservable) used for valuation techniques as follows:
Level 1- quoted prices on active markets for identical assets and liabilities to those being valued
Level 2- quoted market prices for similar assets and liabilities; quoted prices for identical assets and liabilities in inactive markets
Level 3- unobservable inputs generated internally (much more subjective)
The actual assets and liabilities subject to 157’s fair value reporting were already separately identified in prior FASB pronouncements. Consequently, 157 forced issuers to disclose which of the levels of hierarchy their valuation techniques fell within- i.e. Level 1- mark to market, Level 2- mark to maybe or Level 3- mark to myth (BTW I think it was on NC that I had read the three levels identified as such). That would be important information to most financial statement users. So you can see that 157 by itself was actually a good thing.
Conversely, it’s a discussion for another day as to whether the concept of fair value reporting (with its short-term focus) in general is good or bad.
Level 3 – mark to make-believe. Any attempt to value or determine the solvency of any institution must surely begin with zeroing out the value of this component on their balance sheet. It cannot be trusted nor relied upon in any way.
Basically, everybody is lyin’ and the cops (regulators) are playing along.
Anon48 – Thanks very much for that useful clarificatoin.