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.