GLG News by Robert Kemp, CPA

Implications: There are significant arguments today on what should or should not be done to address the current capital market crisis.  In reality, market economies first and foremost rely on trust.  When trust is lacking, the ramifications are significant and far reaching.  The mistrust of one sector multiples into problems throughout other sectors.  A good example is the impact of capital markets on nonfinancial services businesses.  This point is easily seen in the cost of credit, or the lack of credit.  However the impact is much greater than mere credit.  An example is unfudned pension and other post retirement benefit plans (OPEB). The cost of not restoring trust in the capital markets needs to be understood, in all aspects.  The price is high (e.g., government spending and assuming risk) on both sides of the argument.  However all costs, on both sides, must be understood and measured before judgements are made.

Analysis: The impact of our current capital market crisis is far reaching.  That is easily understood.  However the extent of this challenge is not always understood.  An example is pension and OPEB liabilities.

Firms with defined benefit plans assume the imbedded risk within their pension/OPEB plans.  A firm must make up (fund) the difference when its pension/OPEB plan has assets with market values below the present value of it's liabilities.  When the fund experiencing an under funding, the firm must quickly address this.  This has been accentuated in the US by a rather quick funding time table in the Pension Protection Act of 2006 (US law).

As we experience a crisis in our capital markets, the value of pension assets with go down.  Simultaneously we may see interest rates drop, thus increasing the present value of pension/OPEB liabilities.  The net impact is an expected increase in under funding of pension/OPEB liabilities, and the need for firms to contribute more cash to these funds under current law.  This need for corporate liquidity will exasperate the current economic challenges faced in the US and the world.
 
The point is simple.  Supporting and helping restore trust in the US and world capital markets is costly.  Bad decisions were made.  However the cost is more than the lost equity of investment banking firms.  The cost of not acting and restoring trust is found throughout society.

Implications: Fair value accounting, or mark-to-market accounting, is not new.  The debate of how to account for value has been around for decades.  However the implications of fair value accounting, versus historical accounting, are far reaching and often not grasped.  A society needs to be careful in setting accounting standards that may or may not reflect its cultural values.

Analysis: The debate on fair value accounting versus historical cost accounting versus a mix of the two is not new.  In a perfect world, fair value is ideal.  The current move to fair value accounting, away from historical cost accounting, is driven by two forces.  First is the harmonization of international accounting standards (e.g., IFRS).  Second, is better disclosures about the volatility, and thus risk, imbedded in a company's balance sheet (e.g., pensions). 

However we live in a imperfect world, filled with a lot of disharmony and misunderstanding.  The reality is fair value accounting works best where the legal framework of society accepts the subjectivity of market, and thus divergent values (e.g., Europe).  The culture of the United States provides a very open legal system, based on ease of access.  We can see this with contingent fees for lawyers and the high number of lawsuits.  However, coupled with human nature, this may create significant problems when our (US) accounting methodology becomes more subjective with fair value accounting.    Simply, people hate to admit they made a bad investment decision.  People love to blame bad information for losing money.   I am not sure we have grasped the fact that our society, so long dependent on historical cost numbers, is culturally ready to accept more subjective fair value numbers.

The bottom line is, with or without SOX, corporate management and their auditors are in for a rough ride as we transition to fair value accounting.  First, investor expectations need to adjusted.  Second, our legal system needs to adapt.
  

Implications: To accept or reject an offer to sell all or part of a company is a challenge.  There are two issues.  First is the maximization of shareholder value.  The second is understanding the basis of conflicting valuations. 

Analysis: In entertaining an offer to sell all or part of a company, a company's board must embrace two issues.

The first issue is to whom does the company belong.  Often political, agency, and other such issues get involved.  However the ultimate question is whether the shareholders have more value with retaining or surrendering the company/division.

The second, and related issue, is how that value is created.  Fundamentally the value of a company is equal to the present value of the expected benefits from owning that company.  As such, it is a function of the quantity, timing, and risk of the expected future benefits from ownership.  Different perceptions of  these benefits create different valuations.  Different perceptions are created by different strategies.

Which bring us to the retail industry.  The industry is a mature business filled with risk.  The challenge Woolworth, or any potential seller of a company must deal with, is basically who can compete by creating a strategic competitive advantage.  Can current management do better than the acquiring company?  If not, then sell if the valuation is fair.  If yes, hold onto the company and create value that exceeds the offered price.  It's a Darwinian economic world, based on survival of the fittest.  The question is "Who can survive best?" 

Which brings us one step further.  The survival question must also be tainted with the question, "Is creating economic value feasible through operations?"  Too often investors forget that liquidation value can significantly exceed the benefits generated through continuing operations.

The bottom line is simple.  The bottom line deals with maximizing value and understanding the basis for difference in perceived value.

Implications: 1.   Banks create value for shareholders by creating value for customers.  Much of that value to customers is embedded in information systems. 2.   The business of banking evolves quickly, forcing banks to evolve their competitive strategy and resulting advantage.  Information systems are at the heart of this evolution. 3.   The recent challenges of risk management will only accentuate the oversight of regulators, requiring banks to seek better information systems (e.g., more accurate, timely, and integrated information). 4.   As noted by the article, this will create a boom for consultants and providers of information systems.

Analysis: Banks and all financial intermediaries rely on competitive advantage embedded in information.  The industry is Darwinian, forcing firms to survive by superior information, used in a superior manner. 

This business is more than merely raising and investing quantities of capital.  It deals with risk.  As the recent challenges have shown us (e.g., sub prime), banks and financial intermediaries are not where they need to be in recognizing, measuring, understanding, managing, or pricing risk.  The cause, and ultimate solution, to this risk management challenge lies in information, specifically enhanced information systems.
 
From shareholders, to customers, to regulators, and beyond, the financial world will never be the same.  To survive today and in the future, financial intermediaries must have enhanced information via improved systems.  The recent turmoil in markets is a prelude to a boom in the information business.

Implications: 1.  Value is defined by risk.  Risk deals with uncertainty of the future.  How a firm manages risk is a major determinant of its value. 2.  Accounting standards are dedicated to reporting the past.  Given it is the past, there is little risk or uncertainty regarding such events.  Merely reporting the past does not give the financial analyst the insights needed. 3.  FASB 161 tries to bridge this gap between past/present and the future.  It attempts to make management disclose intent.  It attempts to answer the following question: "How will current actions and positions affect future performance?"      

Analysis: The following is a summary of FASB 161: http://www.fasb.org/st/summary/stsum161.shtml


FASB 161 is a significant improvement in the way derivatives are disclosed.  The new FASB attempts to supplement previous FASB's (e.g., 133), by making management disclose intent and logic in their derivative positions and related risk management.

As most realize, risk management is a critical element in determining value.  Being able to evaluate this activity is clearly an improvement.  Financial analysts will have an improved view of a firm's risk management activities (e.g.,strategy, effectiveness, cost/nb
benefit, etc.)

Implications: 1.    Investing in Asia has three benefits.  First, there are the returns from investing in environments that show greater growth potential than in the West. Second, there are the returns from investing in opportunities denominated in currencies that are forecasted to appreciate. Three, there is the benefit of diversification. 2.     The costs, or risks, of investing in Asia are threefold: First, there is the risk that high growth opportunities present. Second, there is the risk of investing in a depreciating, not appreciating currency. Third, there is the asset-liability risk inherent in all financial intermediaries, particularly pension funds.

Analysis: The lure of investing in Asian opportunities is obvious.  Asia is a growth market denominated in currencies that are projected to appreciate.  Likewise, any good portfolio should have a well thought-out strategy of global diversification.  However there are costs and risks.  Most investors recognize the costs, or risks, associated with growth markets and currency markets.  However, when pension funds invest, pension fund managers must also deal with asset-liability issues.

Pension funds managers can no longer simply maximize return for a given level of risk imbedded in the assets.  Pension fund managers must also recognize that they must consider the duration of investments versus the duration of the pension labilities.  Investing in private equity is a challenge.  However the question becomes, "How does this investment match up with the source of funds?" 

This issue is not just for public pension funds, as addressed in this article.  It is also an issue that all pension fund managers must address (e.g., corporate).   Society must accept the risk for poorly managed public pension funds.  Corporate shareholders must  accept the risk of poorly managed corporate pension funds.

Implications: 1.  Countries adopting IFRS are not always adopting the same standards.  If you look closely, the term "as adopted' is being used a lot (e.g., China).  What that means is countries are adopting IFRS in principle, but are differing on interpretation and actual application/practice. 2.  The end result is the need for financial analysts to become more educated and dig deeper into financial statements.  The idea that we will have one set of standards, simplifying analysis, is false.  Analysts must begin to appreciate how each country is "adopting" IFRS.   3.  Accountants must likewise be sensitive to the "as adopted" challenge.  This goes beyond understanding and dealing with different approaches in different countries.  It also deals with investor expectations and the legal structure within and between countries.  Unless accountants grasp changing investor expectations, they will find themselves in a legal nightmare. 

Analysis: The drive for one consistent, comprehendible set of accounting standards is a noble and desirable quest.  However we live in a diverse world with differing cultural norms (e.g., view of wealth, access to legal systems, etc.).  Culture and resulting values ultimately drive things like accounting standards.  We may say we will have a consistent set of standards with IFRS.  However if we look closely, the "as adopted" phrase shows we will still have a lot of inconsistencies and differing approaches.

What this means is that we will always have differing accounting standards as long as we have differing cultures around the world.  As we become more of a global, one culture population, we become more homogeneous in values.  This homogeneity permits us to move to one set of accounting standards.  However we are moving.  We are not there.  Thus countries are adopting IFRS in principle, but are diverging in interpretation and practice (e.g., pensions).

The bottom line is this will not simplify the work of financial analyst or accountants.  For the foreseeable future, analysts must remain dedicated to education.  Also for the foreseeable future, accountants must remain sensitive to the expectations of investors/analysts and the legal systems in which they operate.  What that means is more disclosure by accountants, and more appreciation/sensitivity by analysts.
 

Implications: The reduction of the PBGC's deficit reduces pressure on Congress to take action that could impact corporate values.   Such action would most probably hurt corporate value by adversely affecting cash flow and risk.

Analysis: The Pension Benefit Guaranty Corporation (PBGC) has been running a deficit for a number of years.  Although there is no immediate liquidity crisis in the PBGC, long-term solvency is an issue.  To make sure the PBGC is solvent, Congress has taken actions to relieve this pending crisis (i.e., Pension Protection Act of 2006).  If the PBGC deficit continued to grow, Congress would be forced to do one of the following:
1.    Subsidize the PBGC through taxes, etc.
2.    Increase premiums for covered pension plans/firms.
3.    Increase the power of the PBGC to levy fines, liens, etc on firms with under funded defined benefit plans.

The first alternative is the least attractive to Congress.  This leaves the last two alternatives.  Both would negatively impact the cash flows and risk of firms with defined benefit plans.

The bottom line is simple.  This reduction in the PBGC is good news for firms with defined benefits plans.

Implications: 1)  The PBGC increasing the amount of insured benefits for qualified, defined benefit plans is a normal, annual event. 2)  Ignoring the impact of this increase on firm valuation can be problematic. 3)  Financial analysts, following mature and declining industries and firms, must pay particular attention to this increase due to solvency and liquidation issues. 

Analysis: Each year, the Pension Benefit Guaranty Corporation (PBGC) revises the maximum pension it will guarantee. This year the limit was increased from $49,500 to $51,750, or a 4.5% increase. This annual escalation is normal and to be expected.

What is important to realize is the impact of this increase. The PBGC's goal is that all defined benefit plans meet all pension promises. However it only insures such promises up to a limit. All promises above this limit are uninsured. If a firm, with an underfunded defined benefit plan, gets into a solvency problem, the PBGC can place a lien on the firm's assets up to the insured amount. All amounts above the insured limit are general creditors. Thus, as the limit increases, the financial implications for valuation also increases.

The PBGC is responsible for adequate funding of all qualified, defined benefit pension programs in the U.S. When a pension fund is well funded, an increase in the limit has very little impact. However when a firm's pension fund is not well funded, the PBGC can have a significant impact on the firm's operations and possible liquidation. 

Financial analysts need to be cognizant of this fact, particulary for mature and declining industries and firms.  The valuation of such firms can be altered by the PBGC's claim.

Implications: Unfunded pension and OPEB benefits (e.g., Other Post Retirement Benefits - health care) have little or no priority of claims in bankruptcy, in relationship to other forms of debt.  As political currents change, the possibility of radically changing this situation also changes.  (See source article.)  If pension and OPEB liabilities gain higher priority in bankruptcy, the imbedded risk in other forms of debt will increase.  This increase in risk will ultimately force higher required rates of return and thus lower values. Financial analysts need to be aware of this when pricing such debt and related equity.  

Analysis: When a company files for bankruptcy, the company's pension and OPEB liabilities have little priority of claims regarding debt.  It is only higher in priority to equity.  Thus pension/OPEB recipients, or their agents (e.g., unions, PBGC, etc.), are often left with little legal position.  An example is US Airways bankruptcy.

If legislation is passed to change the current law, two things may and probably will occur.  First, it will be harder to bring bankruptcy companies back as economically viable entities.  Second, pension/OPEB liabilities may force other forms of debt to bare higher default risk.  This higher default risk will mean lower values for such debt.

The bottom line is simple for financial analysts.  The pension/OPEB risk currently born by employees could be shifted to holders of other forms of debt and equity.  This has significant implications for valuations.

Implications: Dr. Mangieor's analysis is insightful and correct. Investors need better pension/OPEB disclosures regarding risks. However all the risk within a pension scheme must be recognized, understood, and managed. Too many times the risk within a pension/OPEB scheme is viewed as having a single dimension: default and market risk. This is problematic.

Analysis:  Risk analysis is dependent on disclosure. Dr. Mangiero's analysis is correct that current accounting standards do not adequately provide the investor enough insights to grasp the risk within a pension (or OPEB) fund. However too often such risks are too narrowly defined. All risks, within a pension/OPEB scheme must be appreciated.

There are three fundamental risks within a pension/OPEB scheme. First is the uncertainty associated with the ultimate amount and timing that the scheme or fund will pay to the retired employee (i.e., liability). Second is the default and market risk imbedded in the investment portfolio. Third is the interaction of the pension/OPEB portfolio (i.e., assets) and the pension/OPEB liability.

In a defined contribution plan, these three risks are born by the employee. However in a defined benefit plan, the sponsoring firm accepts these risks. Thus the value of the sponsoring firm is directly related to how these three risk are managed. All too often, due to lack of understanding and disclosure, the pension/OPEB risks are neglected until they become overwhelming (e.g., U.S. auto industry).

FASB is wrestling with better disclosures regarding the pension liability (e.g., more disclosure of assumptions) and asset quality (e.g., composition of the portfolio). In doing so, they are enhancing the investor's ability to recognize and measure the first two risks within a pension/OPB scheme. However FASB should not forget the third major risk, asset-liability issues. Example: How the duration of the pension/OPEB assets and liabilities relate is very important.

A pension/OPEB fund is a form of financial intermediary. Too often this has been forgotten. Too often the assets are managed to maximize return, thus lowering the cost of funding to the sponsoring firm. Too often the risk and return relationship within a pension/OPEB fund has been neglected. One cannot forget that the risk within a sponsoring firm's pension/OPEB fund ultimately is imbedded in that firm's value.

Pensions fund/OPEB risks have three dimensions. FASB must enhance disclosures of all three dimensions. Financial analysts must recognize, measure, and assess all three dimensions of pension/OPEB risk. This will enhance the ability to evaluate, and ultimately value, the sponsoring firm.

Implications: US auto manufacturers face a huge dilemma.  To be competitive with Toyota and other non-US auto manufacturers, they must lower health care costs and unfunded liabilities.  (This is well documented in the referenced article.)  What is interesting is the impact on value from both the the firms' perspective and the UAW's perspective.

Analysis: The issue facing US auto manufacturers and the UAW is a trade off of risk and return.  The actual form of agreement is still being debated and negotiated.  However the implications are visible.

Most financial analysis addresses the cost of health care.  (The estimates of how much health care costs, per US automobile, varies.  However it is significant and puts US auto manufacturers at a competitive disadvantage.) 

In addition to cost reduction, US auto manufacturers must also eliminate the inherent risk with such programs.  It is the risk that is too often neglected in financial analysis.  If GM, Ford, and Chrysler are able to successfully fund and transfer the OPEB liability to the UAW, the over risk premium the market assess these firms should go down.  (Note: How these firms fund this liability is another matter.  Example: firm stock.)  Basically the firms will have transferred a lot of the OPEB risk to the UAW.

However this is not a win-lose situation.  The OPEB liabilities of GM and Ford are greater than the equity value on their balance sheets.  (Note: Chrysler is now private.)  As the rating agencies have noted, default risk dominates the value of US auto manufacturers.  If the UAW accepts the OPEB funds and thus risks, it also lowers the default risk that it currently absorbs.  (Note: OPEB liabilities have little priority of claims in bankruptcy.)  Financial analysts must realize that the unfunded OPEB liability on the balance sheet of US auto manufacturers is also the receivable on the employees'/retiree's (or their agent's) balance sheet.

The bottom line is such a program would reduce the "total" risk of US auto manufacturers without significantly increasing the "total" risk currently being absorbed by the firm's employees and retirees.  What the proposal does is shift the employee/retiree risk away from employer default  risk to fund operating risk.  This fund operating risk deals with the recognition, measurement, and ultimately management of funds assets, payments to employees/retirees (liabilities), and matching of assets and liabilities (e.g., duration).

In summary, financial analysts must look at the risk implications in this proposal, not just the cost implications.  The risk could be a win-win if properly executed.

Implications: The key implications of Rank Group's actions are threefold. First, it is harder for companies to borrow from employees with off balance sheet pension schemes.  Disclosure requirements have increased (i.e., FASB). Second, pensions have always been a too-often neglected risk dimension in corporate valuation.  With more disclosure, this risk dimension is being recognized, appreciated, and used in pricing value. Last, the reasons for a company to retain influence over its pension fund are diminishing.  Regulation (e.g., Pension Protection Act) is requiring more discipline in the assumptions used to evaluate pension obligations and the funding of pension obligations.

Analysis: Rank Group closed its defined benefit plan in 2000. However its pre 2000 pension liabilities, and related assets, still weigh heavily on the group's management. This is due to two major related forces.

First, new disclosure requirements are giving investors a clear picture of the company's obligations from the pension fund.  Example, the net PBO (projected benefit obligation less assets) is being put on the balance sheet.  No longer can companies hide the closet leverage of borrowing from it's employees. The full impact of unfunded deferred compensation is being revealed in comprehendible terms and format.

Second, with this disclosure, the inherent risk in defined benefit plans is being better understood by investors. With this understanding, the risk imbedded in defined benefit plans, and the sponsors of such plans, is being used to price the sponsors' debt and equity.

The result is simple, particularly for companies that have closed the company's defined benefit plans.  There appears to be diminishing benefit for a company to retain influence over the investment decisions of its pension plans.  It makes sense for a company to sell its pension obligations and assets to institutions that have the expertise to better manage the risk and return needed to fulfill the pension promise.  Companies need to get rid of the risk inherent in such pension plans.  If such a move is properly handled, value can be enhanced for all concerned (e.g., sponsoring company, employees, purchaser of fund assets/liabilities, etc.).

Implications: Too often the managers of pension funds use an objective of maximizing return.  However in doing so, they neglect risk.  In the volatile markets of today, the focus on returns, while neglecting risk, is causing problems.  It's time to stake a step back and rethink the management of pension funds. 

Analysis: The management of a pension fund has a single objective.  That objective is not to maximize returns in order to minimize the cost of funding by the corporate sponsor.  The objective is to provide the deferred compensation that the pensioned employee has earned, at the agreed upon future date.  In other words, safety and soundness is at the heart of investing pension funds.  The phrase "safety and soundness" (taken from the banking industry) is another way of saying prudent risk management.

There are three types of risk within a pension fund.  First, there is the risk of determining the amount and timing of the pension liability/ payment.  (Clearly defined contribution plans have a lower level of this risk than defined benefit plans.)  Second, there is the default risk in the pension fund's assets/investments.  Third, there is the risk of matching the maturities, or duration, of the pension liability and the pension assets (e.g., asset-liability issues).

Clearly too many pension fund managers have accepted too much risk (e.g., investing in hedge funds.)  Pension funds must invest strategically.  Pension funds must have a risk management program that recognizes, measures, and manages the total risk profile of the fund.  That means recognizing all three risk elements, and how these elements interact.

In summary, simply chasing returns will not suffice in the long term.  The trick of managing pension funds is balancing risk and return.

Implications: The process of managing pension plans (defined benefit plans) is too often simplified and neglected due to its long-term nature.  Like Dr. Mangiero, I also agree that the degree of sophistication needs to be raised.  However to do so, all risks within the process must be recognized and managed in an integrated framework. 

Analysis: Defined benefit pension plans are dinosaurs that are imbedded in the past.  However, although they grow more extinct, they still roam our economic world.  What is troublesome is the way we manage such giants has not significantly changed over time.  They are perceived as ever growing, very long-term liabilities that permit investment managers great freedom in choosing an appropriate strategy.  Too often this strategy is focused on maximizing return, and thus reducing the sponsor's costs.  Too little attention has been paid to the risk dimension of investing pension funds.

In reality, proper risk modeling begins with risk recognition and measurement.  Pension plans are financial intermediaries.  The assets ultimately support the liabilities.  To fully grasp this dynamic process, one must first recognize the risks/uncertainty in the liability (i.e., pension promise).  Next, the risks in the assets (i.e., pension investments) must be recognized.  Last how the risks in the liabilities and assets interact must be recognized.  Risk is everywhere in this process. 

The pension promise (i.e., liability) is full of uncertainty with mortality rates, inflation, payment revision from contract renegotiation, etc.  As Jack Treynor noted in the 1970's, there are numerous dynamics with this liability that must be understood (e.g., pension put option, PBGC insurance, etc.)   Pension assets have more than default risk.  Pension assets have market risk due to time and changing economic conditions.  Last, how pension liabilities and assets interface are critical.  This asset/liability issue is about timing of expected cash inflows and outflows (e.g., duration and immunization).

Today, financial analysts, sponsoring corporations, and pension fund managers must realize that past tools are no longer adequate.  A pension fund exists to deliver the promises of corporate management for lifelong earnings to workers.  As such, the first and foremost objective must be risk.  Workers cannot shoulder the uncertainty created by poor management of pension funds.  Risk management, and the derived valuation, must dominate the perspective of all.   No longer can everyone assume that pension investment strategy should focus on return, and that risk will be okay given the long-term nature of pension liabilities.

Implications: 1.    Convergence of U.S. and international accounting standards is coming. 2.    The pace for this evolution is quickening. 3.    This convergence is troublesome, not because of its goals, but because of the expectations of financial statement users. 4.    Users of financial statements must be educated to the differences in accounting standards, and the implications that different approaches yield.  These implications also include legal issues/recourse.

Analysis: Convergence of global accounting standards is coming.  The need is evident as global markets converge.  What is troublesome is the lack of understanding regarding glibly accounting standards.  Specifically, accountants, financial analysts, investors, and legal systems must adapt.  Valuation models must reflect a different level (quantity and quality) of information. 

It is well documented, in this article and others, the difference in U.S. GAAP and IFRS.  The former is dominated by conservatism and historical cost.  The latter is dominated by a fair value or value-based approach.  Likewise it is well documented the pros and cons of each approach.  Both have costs and benefits.

What is not fully understood is how each methodology affects the process of valuation.  Financial analysts and investors now must deal with different levels of information in assessing risk and return.  To pull this evolution off, a massive amount of user education is needed. 

Next, accountants must be prepared to disclose the methodology used in deriving value.  No longer can a provider/user assume a given set of old and accepted practices.  Already burdened by lengthy disclosure, users must be prepared to dig deeper into the footnotes, etc.   

Third, the legal system, in which investors operate, must adapt.   The courts must stand behind accountants that give their best effort.  Convergence of accounting standards will mean more subjectivity.  Legal standards, used throughout the world, must also converge.

In summary, the world of accounting is evolving quickly.  Accountants, financial analysts, investors, legal systems, etc. must also evolve.

Implications: The real challenge for the PCAOB, auditors, and financial analysts is not the lack of expertise.  The real challenge is twofold: 1.    The user of financial statements must be educated and revise their expectations. 2.    The US legal system must adapt.

Analysis: The dialogue between Professor Miller and Sarah Johnson is intriguing.  However there needs to be additional points.

First, I agree with Professor Miller about the lack of expertise.  Such a point is not justification for avoiding fair-value or value based information.

Second, I also contend that accountants deal with fair value everyday.  Accountants constantly benchmark current value with approaches such as lower-of-cost-or-market and impairment.

Third, because of the litigious US society, accountants are conservative and rely on historical cost measures.  The quickest way to get sued is to overstate value.  Thus when they look at value, US accountants will write-down historical cost when it overstates fair value.  What US accountants will not do is write-up an appreciating asset. 

Fourth, I am somewhat perplexed with the "us versus them" attitude many take in this debate.  The purpose of accounting is to provide useful information.  In reality, the financial disciplines are not discrete, but a continuum.  Accounting, finance, and economics are all tied together in the process of measuring and creating value. 

Fifth, the discussion about fair value accounting adding risk is unfounded.  In reality, user uncertainty is elevated when the information they use (e.g., historical cost) is insufficient and does not reflect economic reality.  The challenge is creating an educated user of financial information.

In summary, the only thing holding the US accounting profession back from embracing value-based measurement is the need for educating the user and legal reform that inhibits unjustified lawsuits.  That's my opinion.

Implications: The US accounting profession has long dealt with fair value.  However how US accountants deal wit fair value is first a function of the US legal system.  Until the US legal system changes, the US accounting profession will always have challenges.  Thus the US accounting profession will cling to historical cost methodology.

Analysis: Mr. Grover's piece clearly lays out the issues of converging US and global accounting standards (i.e., FASB versus IASB).  However there is a fundamental issue that must be recognized and addressed if such convergence has a chance.  The issue is culture and law.  Different countries have different cultures.  Different cultures have different value systems which are reflected in their different legal systems.  Different legal systems produce different accounting systems.

US accounting standards deal with fair value, but in a very conservative way.  Examples are lower-of-cost-or-market and impairment.  US accounting standards have no problem with understating asset value or overstating liability value.  US accounting standards have a problem overstating asset value or understating liability value.  US accounting standards are conservative, procedural based, and minimize subjectivity by using historical cost.
 
International standards embrace fair value in most elements of financial statements.  The IASB (International Accounting Standards Board) recognizes that fair value does inject more subjectivity, but feels the benefits of such an approach outweighs its cost.  International standards are more principle based.

The difference in approaches is embedded it the US legal system, and how that system differs from other countries.  The US legal system is designed for all to have easy access to, at low cost, the court system.  Thus it is neither hard or costly to file a law suit.  This is not the case around the world.  When investors lose money in the US, the first group to be blamed is the group that furnished the information (accountants).  Whether justified or not, US investors love to sue accountants to recover loses.  The ease of suing accountants fosters the large number of unjustified law suites against accountants.

To combat that, US accountants become conservative.  Nobody ever sues a US accountant for understating asset value or overstating liability value.  Investors sue US accountants for over stating asset value or understating liability value.  Thus the bias to historical cost that can be verified.  Thus the bias to writing down historical value, but not writing up historical value, when market conditions dictate.

In summary, convergence of global accounting standards is a very desirable goal.  However this may not be feasible due to differing value systems throughout the world (e.g. legal issues).

Implications: As the author notes, pension managers often neglect risk management.  The question is, "Why?"  To understand the answer one must look for incentives to manage pension risk.  One must focus on the accounting for pensions.

Analysis: Do managers of corporate pensions (i.e., defined benefit plans) understand and appreciate the need for risk management?  I believe the answer is "yes."   Why don't pension managers do a better job?  Look to the incentives.

The management of pension funds deals with managing resources (assets). Such resources should be managed so they will be adequate to meet the promised claims of pensioned employees, both in quantity and time.  There are two main risks associated with this tasks.  First is the risk of investing in securities that generate adequate returns.  Second is the risk of matching sources and uses of funds.   It is an asset-liability issue.  Such an issue should focus on immunizing the pension funds exposure.

Accounting rules, new and old, do not adequately disclose investment risk.  However accounting rules do not even try to disclose the asset-liability risk.  There is little incentive to manage this risk exposure.  

Accounting rules focus on costs.  To lower costs, pension managers seek higher investment returns.  To do this, they adopt higher risk strategies.  Without adequate disclosure, financial analysts cannot see the risk the firm is taking.  Thus the risk is subject to improper pricing.

The lack of risk management of pension funds is an incentive issue.  It is founded in inadequate accounting disclosure.  Improved transparency would enhance the work of financial analysts.  It's all about accountability and transparency.

Implications: The problems of subprime lending are hot topics.  Lack of underwriting standards and poor pricing are the primary concern.

However lenders need to understand the cure or reaction to such concerns can cause even more harm.  Financial analysts need to understand how their clientele (e.g., banks) are coping with the challenges.  Financial analysts must consider the proposed solutions.  The solutions may cause as many, if not more, problems.  The issue is value at risk.

Analysis: Nobody debates that subprime lending is creating a lot of problems for financial institutions (e.g., Washington Mutual) and the overall economy.  These problems are the direct result of an expanding economy, poor underwriting standards, and poor pricing standards.  The desire of financial institutions to create value was driven by growth and volume, balanced with inadequate consideration of all risks.  This resulted in taking too much risk for a given price.  Adjustable rate mortgages (ARM's) are prime examples of this.  Customers were loaned money that they could afford only if interest rates remained low.  Lenders justified the low rates with two facts.  First, the customer's converge ratio was deemed adequate (current debt service to available income).  Second, financial institutions were funding the ARM's with floating rate money.  In terms of asset-liability management, financial institutions were not directly taking interest rate risk.  They were hedging the interest rate risk with an immunization strategy.  (Note:  Lenders transferred their interest rate risk to their customers.)

However financial institutions failed to look at the interaction of default and interest rate risks.  As interest rates increased, customer coverage ratios dropped, causing default.  The push to lower interest rate risk (asset-liability) caused an increase in default risk.

What is interesting are the many cries for institutions to stop lending money on a floating rate basis.  The referenced article is a example of this.  This strategy does help in evaluating and managing default risk.  Current coverage ratios are more reliable predictors of future coverage rations.  However this ignores the asset-liability issue.  How does a financial institution fund long-term loans?

Financial analysis must look at a financial institution's "total" risk profile.  What is critical are the answers to the following two questions:
1.    What is the total risk profile of the financial institution, and is that risk level appropriate for this financial institution?  Don't forget regulation.
2.    Given the total risk profile of the financial institution, is the pricing/return adequate?