Permit obtained for more creative accounting

A country's laws, policies and regulations are set by government. However, such things can be changed in a short time if the concerned parties pushed their case hard enough. On 2nd April, the Financial Accounting Standards Board (FASB) in United States allowed banks more discretion in reporting the value of mortgage securities.

Good news? Surely it will be for banks. Perhaps in this coming quarter, we can expect lower impairment charges and write-down values. To me, this is a move of desperation. There is no more credibility in doing accounting. When the market is fine, nobody made noise as most were raking in copious amount of money. Now that the chips are down, banks want to have the freedom to set their own asset prices.

Valuation of assets and liabilities is a malleable matter. Long ago accountants grappled with the issue of which master they should serve, since their constituents can have conflicting interests. According to best practices, accountants should chosen the path of conservative reporting as it has shown to serve most constituents well. It may not be fair to all but life is not always fair.

Generally, a bank's assets are made up of the following:
1) Cash
2) Securities
3) Loans
4) Other assets (plant & equipment)

With the investment banks, there will be an extra category of asset based on derivatives and other financial instruments.

Loans represent the majority of a bank's assets. A bank can typically earn a higher interest rate on loans than on securities, roughly 6%-8%. You can find detailed information about the rates earned on loans and investments in the financial statements. Loans, however, come with risk. If the bank makes bad loans to consumers or businesses, the bank will take a hit when those loans aren't repaid. Because loans are a bank's bread and butter, it's critical to understand a bank's book of loans. Due to the worldwide boom in real estate in recent years, a large portion of loans are back by properties.

The biggest problem facing banks now, are that derivative asset values are virtually impossible to estimate, many loans are in forbearance if not default, and securities based upon mortgages are underwater and untradeable. Banks have a very difficult time marking to market because there is no market. There will be no simple solution in sight. Nevertheless, banks are posting huge losses as they need to mark down their assets every quarter according to the old accounting rules.

Will the new accounting rules set by FASB change anything?
Sadly no. The assets on the books of the banks are trash and they and the government know. That was why in the absence of buyers, the government has to step in to mop up the 'toxic assets' as stated in Geithner's plan. The main objective is to create a market for the underwater and untradeable assets. Even though the transacted price of the assets are low, the government just want to be able to buy time and ride out this downturn so that the assets need not be written-off. If things turn out well a few years down the road, the government may even book a profit at the exit point.

Marking asset to fair value will cause more pain in a downturn. But when asset prices move back up, profits can be recorded in the earnings statement. It is well-known that FASB made the rule change under great political pressure. However, such a hasty implementation may have huge unintended consequences. All parties involved could have inadvertently planted the seed for the next financial disaster/bubble.