Does a Firm Insist on Historical Cost Accounting? Short!

Jun 23rd, 2014 | Filed under: Alpha Strategies, Asset pricing, Derivatives, Today's Post | By:
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acctgCertain short sellers seem to act on the principle that if a public corporation has a great attachment to book values, in other words to historical cost accounting, in yet other words if it has an aversion to marking its assets to market, that is itself a reason to be suspicious of its business model or its managers’ operational abilities. It is a reason to look at that corporation as a target for shorting.

Why? Well … the concise answer is that there isn’t any good reason to stick with historical costs except reality avoidance. And when a management is avoiding reality, short selling follows naturally.

But: aren’t there any good things to be said on behalf of the use of historical costs? Such as, for example, that their use prevents fire-sale mark-downs?

That is a venerable opinion. In the midst of the crisis itself Mike Huckabee, fresh off his unsuccessful attempt to become the Republican Party’s nominee for President, delivered this opinion: “Instead of asking my future grandchildren to co-sign a $700 Billion note so you could convince yourselves that you have ‘fixed’ this, you should have made some really bold decisions that might have actually addressed the root causes,” he said, apostrophizing Congress. How might the Congresscritters have addressed those roots? He continued, “getting rid of capital gains taxes, changing the mark to market accounting rules that created some of the artificial devaluation of assets, and insuring bad loans instead of actually buying them are all ways that the situation would be addressed without such a huge risk.”

After This, Therefore Because of This

His reference to the accounting rules there was, specifically, to SFAS 157, which had been issued by the FASB in September 2006, and became effective for fiscal years beginning November 15, 2007.

It is that bit of timing that is behind the usual scape-goating of M2M accounting. The early 21st century stock market boom in the United States came to an end in October 2007, when the DJIA hit its then record 14,164.43 and headed south. The following month the new SFAS 157 officially came into force. Also that November, Citigroup announced a $6.5 billion write-down from its derivatives losses. Things got worse from there, snow-balling to and through the collapses of Bear Stearns, Lehman Brothers, and AIG over the following year.

Post hoc ergo propter hoc is the most alluring of fallacies.

But when such claims are tested, they routinely fail. M2M accounting neither caused nor worsened the recession. Recently scholars led by Andrew Ellul of Kelley School of Business, Indiana University, looked into the issue in the insurance industry specifically. They found that “insurers facing mark-to-market accounting tend to be more prudent in their portfolio allocations” than those who use historical cost accounting.

They looked to insurance because although relevant rules vary a great deal state to state, the accountant treatments for speculative assets allowed under the model law of the National Association of Insurance Commissioners makes a useful distinction [“useful’ in a laboratory/control group kind of way] between life insurers on the one hand and property &casualty insurers on the other.

Life insurers who have seen the value of an asset downgraded from investment to speculative are allowed to continue to hold it at book/historical value until the situation becomes really dire – until it is in or near default. That presumably pleases Governor Huckabee.

Disciplined Books are a Good Things After All

P&C insurers, on the other hand, are required to carry a speculative asset on their books at the lower of the book or the market value: just the sort of requirement that irked Huckabee (and many others).

With this in mind, the scholars “investigate asset-level prices during and after the financial crisis and find that the assets held disproportionately more by P&C firms do not exhibit pro-cyclicality in comparison to those assets held disproportionately more by life firms.” This is, in other words, exactly the opposite of what one would expect, were the Huckabee diagnosis sound.

It might occur to you that there is a flaw in this analysis. It is possible, after all, that P&C insurance is relevantly different from life insurance for some pertinent reason other than the particular NAIC accounting rule distinction cited above.

Accordingly, Ellul et al did comparisons not only between the two types of insurer but within each type. “Overall,” they conclude, “the within-insurance-group results confirm that MTM induces more prudent portfolio decisions and limits insurers’ incentives to engage in regulatory arbitrage,” thus dampening rather than accentuating the boom-bust cycle.

Aside from Ellul, the authors of the paper are: Chotibhak Jotikasthira, University of North Carolina; Christian T. Lundblad, University of North Carolina; and Yihui Wang, Fordham University and Chinese University of Hong Kong.

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Author Bio:
Christopher Faille is a Jamesian pragmatist. William James has taught him, for example, that "you can say of a line that it runs east, or you can say that it runs west, and the line per se accepts both descriptions without rebelling at the inconsistency."

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