If Merrill Lynch didn't know the value of the assets on their books and had to take an $8 billion-plus write-down for subprime mortgage-related securities, how can directors and officers insurance underwriters possibly know if financial disclosures are appropriate?
Jack Zwingli, chief executive officer of Los Angeles-based Audit Integrity, a forensic accounting firm, asked the question during the Professional Liability Underwriting Society International conference last month, noting that issues facing D&O insurers thanks to the subprime mortgage crisis are just a small part of a larger challenge–the need to get their arms around the degree of transparency and the quality of disclosure at financial institutions.
"Subprime is the topic du jour and will last a long time in terms of lawsuits and continuing impact. But from a disclosure standpoint, this is really an issue of fair-value accounting," Mr. Zwingli said, referring to accounting rule changes related to the valuation of assets that went into effect on Nov. 15.
Essentially, with new rules–FAS 157 and FAS 159–standard setters are moving to get companies to value assets on a fair-market basis. That means "assets should not be marked on your books at their historical costs. They should be on your books at what they're actually worth today," Mr. Zwingli explained.
While this approach "in concept is a good thing," he said in reality it means companies will be valuing a lot of their assets "based on very obtuse and very subjective reasoning."
The intended consequence is to increase transparency and limit volatility–so users of financial statements "don't see a lot of swings in earnings related to assets and liabilities being reevaluated," he said, adding that it was intended to be "a way to prevent companies from managing their earnings by valuing assets in different ways."
If asset valuation was "open to subjectivity and management biases before, it is wide open now," he said, noting that some recent articles in the Wall Street Journal and other financial publications quote experts speculating that financial institutions may use the rule changes to "game the system."
With companies now allowed to erase their asset values and start over, the question is, "How honest will they be? How selective are they going to be?" he said. "Are they going to use this as an opportunity to take all the bad things off their books?"
Offering guidance to insurers of financial institutions, he said they need to focus on so-called "Level 2″ and "Level 3″ assets, defining the categories as follows:
o Level 1–liquid assets for which there's a market price that are "marked to market."
o Level 2–assets for which there's no ready market price available that are "marked to model." Models might look at comparable assets that mature at the same time or carry the same rate of interest.
o Level 3–assets that will be valued on using "significant unobservable inputs" that are "based on unobservable, hypothetical market behavior," in the language of the Financial Accounting Standards Board.
This last category–the most worrisome–covers the assets that are essentially going to carry values that are "just flat out management estimates," Mr. Zwingli said.
It's like "selling your house and saying, 'I think it's probably worth $5 million just based on some unobservable hypothetical market behavior,'" he offered, referring to FASB guidance.
He reported that accounting professors he's talked to are calling this idea "just crazy." According to Mr. Zwingli, one unnamed professor commented: "People are picking numbers out of thin air."
In addition, he noted that auditors themselves are referring to this as the "20-year problem," because they believe they won't have a handle on how to assess these valuations for at least 20 years.
"We're not even teaching this stuff in school now. So it's got to get into the curriculum for the next generation of auditors to figure out," he said, citing his own conversations with auditors and articles in publications read by auditors–such as CFO.com and Compliance Week, which quote auditors as being worried about auditing management judgments and having "nothing factual" on which to base their assessments.
If auditors have a problem, Mr. Zwingli suggested, insurance underwriters should be even more concerned. In particular, he said, if a senior executive's bonus package is based on the value of the holdings of their company, that executive "might be a little conflicted" in how they would value those holdings.
Even when there has been an independent evaluation of the assets of a company, "you have to view that a bit skeptically because the valuation specialists are being paid by the company," he warned.
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