Transparency – The full, accurate, and timely disclosure of information

Today something happened that most investors and traders did not even know about. Today, the FASB Rule 157 was delayed for one year. The FASB what you say? The FASB is the  "Financial Accounting Standards Board". It is the organization that establishes accounting rules for publicly traded companies. Accounting standards are critical in order to have an accurate and consistent method for which to measure the profit and loss of a company. When the financial officer of a company reports their revenues and all other figures, he or she uses rules established by the FASB. And the same goes with the accountants that firms hire to audit the financial statements , they all have to use the same accounting standards and those standards are established by the FASB.

So what was it that happened today that is such a big deal? The FASB had put together a new accounting rule which, when implemented, would have forced companies to provide more clarity on how they are valuing assets. When a company places a value on an asset they have three methods from which to use. The first is what is called "mark to market", essentially meaning that the value of an asset is based on the current market price, pretty plain and straight forward. The second method is called "mark to model", this one means that there is basically no market price for an asset so the value is based on a model made up of observable inputs. And the third method is one which has no official name, but has been called in the media as "mark to make believe". This one is similar to the mark to model method of accounting with the major exception that there are no observable inputs to accurately gauge from. So when a company calculates the value of an asset based on the level 3 (a.k.a. mark to make believe) they are feeding into the formulas numbers that have no connection to anything real, they are unobservable. Essentially a guess.

The purpose of RULE 157 of the FASB was to provide new guidance to publicly traded companies on how level 3 is to be calculated. In essence forcing them to bring assets out of the level 3 reporting method and move it up to something tangible and to provide transparency. Companies can hide losses in this level 3 "twilight zone" and calculate the assets as unknown or otherwise mark those assets as TBD (to be determined). Instead of bringing the skeletons out , they keep them hidden in the basement until such time when they can unload them or find another way of getting rid of it. Perhaps in hopes of not having to identify the true value of those assets to the shareholders. To me this sounds like an Enron scandal all over again, but this time it is not hiding losses in overseas companies, it is hiding losses in a loophole in the accounting standards.

RULE 157 was going to change that, it was going to force the companies to report the value of those bones in the basement to something tangible. But you know what happened today? Out of the blue, RULE 157 has been postponed for one full year. That’s right, the accounting standard that would force companies to provide more transparency on the shareholders money and the gains/losses of the company has been canceled and will not go into effect now. Do you grasp the meaning of this change? It means that companies and their accountants have been given a year to find a way to bury the bones without having to report the true value. The public investment community should be outraged by this, unfortunately this is not something that makes headlines. The vast majority of the investment community, shareholders, and 401K participants are not even aware of this, or even aware of the Financial Accounting Standards Board.

So what are the implications of RULE 157 being postponed? That is an unknown, for had it been put into effect we would have additional clarity to what is being done with the shareholders money. But without it the problems that the financial institutions are facing may be never fully known, or perhaps they will be known but in bits and pieces. It may even be worse in the long run as the problems could fester until such time they can’t be concealed any longer, and then it could be even worse. No matter what the eventual outcome is, the postponement of RULE 157 is bad for the stock markets.

And by the way.. you want to know what the mission statement for the FASB is? Here it is:

"Serving the investing public through transparent information resulting from high-quality financial reporting standards, developed in an independent, private-sector, open due process"

You have to wonder who it was that convinced them to postpone this rule for one year, which by the way, will be when the Presidential elections are over.

Before I move on to other market events of the day I want to put here the news item that first brought the FASB RULE 157 to our attention:

On November 15th, FASB 157 will officially go into effect. FASB 157 establishes disclosure requirements that reveal to financial statement users how the fair value estimates were produced . The main contribution of Statement no. 157 is to put more pressure on companies and banks to value their assets based on stringent forecasts and estimates of fair value. A fair value measurement reflects current market participant assumptions about the future inflows associated with an asset (future economic benefits) and the future outflows associated with a liability (future sacrifices of economic benefits). Those differences are the source of most income (or loss) for companies. The central component of Statement no. 157 is its description of the "Fair Value Hierarchy", under which there are three levels. Level 1 is the preferred method as valuation efforts are quoted prices in active markets for identical assets or liabilities, with the caveat that the reporting entity must have access to that market (Mark to market); Level 2 involves less-active markets for identical assets and liabilities. This category is ranked lower because the market consensus about value may not be strong. Level 2 is used when there are not any quoted prices available but there are observable inputs. This is known as Mark to model; Level 3 describes inputs as "unobservable," and limits their use by saying they "shall be used to measure fair value to the extent that observable inputs are not available." This category allows "for situations in which there is little, if any, market activity for the asset or liability at the measurement date". It is at this level where questions have been raised with regards to banks keeping sub prime loans and activities buried in their financial’s. An area which is being sarcastically referred to as ‘mark to make believe’. The general belief out in the markets is that the majority of troubled loans have been hidden in Level 3 areas on financial sheets and once this accounting rule is established it will cause banks to address the true value of some of these assets and very likely uncover more corrosion within the credit markets. According to a recent Royal Bank of Scotland report Morgan Stanley has 251% of its equity levels placed in Level 3 assets; Goldman 185%, Lehman 159%, Citigroup 105%, Merrill Lynch 38%. It is this size of exposure that has the markets worried. Royal Bank of Scotland estimates that these banks could account for $100 bln in write downs alone, and the credit crisis could see $250-500 bln in total write downs when all is said and done. Banks must adopt FAS 157 for purposes of the Reports of Condition and Income in the first fiscal quarter of their first fiscal year beginning after November 15, 2007. Thus, banks with a calendar year fiscal year must adopt FAS 157 as of January 1, 2008.

Source: Briefing

The article says November 15th. But it has been postponed until November 15th 2008!

Today’s market saw increased selling towards the end of the day. Stocks were being bought up all throughout the morning before all the gains were taken away, selling hard into the close is always a bad sign of how the smart money is viewing the longer term outlook. 1490 on the S&P remains a significant resistance level  for that index. If the market can manage to get above that level, and stay there for a few days then we will have climbed up through a hole and found some support to hopefully stay above that point. Right now it looks like a tight hole to fit through and it might not make it.

After the market closed, we had another financial institution report substantial losses. Novastar Financial (NFI) was a company trading at $150 a share just a year ago, now they are likely going to end up on the pink sheets as they are likely to be de-listed from the NYSE. Their stock price in after hours is now $2.80.

The problems associated with the sub prime disaster are not over. Companies like Ambac Financial (ABK) and MBIA Inc (MBI), who provide financial guarantees and other forms of credit insurance are likely to be in even greater danger in the coming months as more of the financial crisis unfolds. What about the earnings of companies that do survive? A financial report I read today shows that most mortgage lenders and other financing companies have tightened their lending guidelines even further, reducing the number of people and business able to secure credit. So you think the housing crisis is bad now, just wait… for you may have seen nothing yet.

The Asian markets have turned negative at the time of this writing and the S&P futures have also crossed into red territory.