Kenneth D. Gartrell

By: Kenneth D. Gartrell

A recent New York Times article raised issues about the application of market valuation rules to the investments in mortgage debt securities by major financial companies such as Citigroup, Bank of America and Wachovia. The article highlights efforts by managers of the companies to partially offload some of their current market woes onto the accounting profession. While there might be isolated instances of accounting rules causing unexpected drops in stock prices, it almost always works the other way.

Understandably, executives at the largest financial companies who have watched their stock prices fall anywhere from 50% to 75% since October 2007, are looking for something to blame besides themselves. In casting about, the latest scapegoats de jour are the accountants and the markets.

What the executives say through spokesmen is that the FAS 157 which requires financial assets to be “marked to market” is faulty. They claim poor market comparables render the wrong value because there are no observable efficient markets for certain complex instruments in their asset portfolios. Instead of marking to market, management believes that “marking to model” or more specifically an analysis of the cash flows under the contracts together with certain estimates of financial conditions of the future (such as market volatility and interest rates) provide a more accurate valuation.

All the jockeying signals a raft of coming litigation against financial companies as plaintiffs will be looking to collect damages for large short-term drops in stock prices. Plaintiffs are likely to allege management failed to warn about the problems when they could have and should have. Management apparently wants to say the accounting is wrong and that the associated accounting losses produced unwarranted drops in stock prices.

Accounting methods and their impact on stock prices.

When negative results occur in stock performance, a common reaction is to focus on the historical accounting. The facts, however, do not fit very well. For most of the major financial companies the slide in stock prices began well before the underlying financial results were calculated and reported for the year ended December 31, 2007. The losses then continued well after the first earnings announcements made in mid-January 2008.

Economists have studied the relationship between stock prices and accounting earnings in detail. Our general conclusion is that the causal connection between earnings surprises and stock price changes is limited. On average, less than 15% of the changes in stock prices can be explained by unexpected changes in accounting earnings. When there is a significant impact, it is usually fully accounted for within one or two days of the first public announcement. In the case of the financial services companies, the trends in stock prices along with the timing of accounting earnings announcements are not very convincing about the relationship between the two measures of performance.

Among financial firms, the deterioration in stock prices of 50-75% has been a pattern of steady erosion. This fact by itself cannot refute the idea that the accounting surprises moved the price to some degree, but it is certainly clear that the accounting alone is not the root of the general decline nor is it a sufficient explanation of the overall decline in prices.

In almost all cases markets move ahead of accounting. That is why the causal link between stock prices and accounting earnings is so weak. Markets are forward looking and, in the absence of fraud, they adjust to most economic factors well before the historical accounting is completed. Accounting is a control device; it looks back in time and rarely tells much about future market conditions. The markets have likely recognized the reasons for stock price declines months or weeks before the accounting is done. A company, for example, which reports its earnings on December 31st does not provide financial statements much before mid-February of the following year. What news is contained in the financial statements usually moves the price of the stock earlier and, in the absence of fraud, not later than the first earnings announcements in January of the following year.

Is management out of touch with the markets?

Rather than this being a situation where the market is wrong and the accounting to blame, it is more likely a case where management was not in tune with market conditions. It is also far too familiar that for some reason management has not been forthcoming about the risks and returns of the assets in their portfolios. Investors and analysts are sufficiently sophisticated to evaluate management with an understanding of the limitations of accounting information. They understand the accounting may not capture the economic reality of each situation. But they need management insight to get at a more accurate valuation. They also have every reason to expect management is ahead of the markets.

While accounting principles offer little insight into the future, they do shed light on management performance. Marking to market does not provide information for securities pricing, but it does confront management with a need to pay attention to business. Shareholders have a clear right to expect that management knows what they are doing. When there is an independent market-based evaluation of a company, the accounting principles reduce the room for opportunities to “manage the earnings” instead of managing the business. The accounting does not determine the stock price, but it provides a reasonable basis to challenge management. Essentially, the accounting is analogous to requiring managers to look in the mirror and assess their own performance accurately.

There is nothing which inhibits management from making a case for different valuations than provided by generally accepted accounting principles. If management has a reasonable basis for alternative valuations, the securities laws and public reporting requirements do not interfere with their ability to communicate a better informed valuation of assets. There is no reason that competent managers cannot improve the valuation of their companies by competently communicating to investors how it might be that accounting standards fail to accurately reflect their performance.