The perils of mark-to-market accounting – the Blue Sky example

When I initially studied accounting (many years ago…), the broad standard of what value to put assets on the balance sheet for, was “the lower of cost or market”. In other words, when you acquired an asset for $100, it would stay on your balance sheet for $100 unless it was clear the value had deteriorated. If the value of the asset had increased, you wouldn’t change the value on the balance sheet.

Over time, in most jurisdictions standards have shifted to a general rule of “mark-to-market”. The standard setters have generally had plausible arguments for this. After all, the purpose of the balance sheet is to represent the financial position of the company as best and realistic as possible. Clearly, keeping an asset at the lower of cost or market is more conservative, but not necessarily realistic. Another reason often quoted is the discrepancy that arises between two firms when one builds its asset base itself, while the other does it through acquisition: the acquiring company will have paid a market price, and will have the same assets for a different value on their balance sheet.

These (and other) arguments are certainly valid. However, there is a big issue with implementation. Of all assets that can appear on a company’s balance sheet only a small subset has readily observable market prices (think equities, bonds, and other liquid financial instruments). There is certainly another subset where there is less liquidity, but estimates can be made reasonably well (eg, real estate). But happens with the rest? To answer this question, accounting standards tend to be supplemented with books full of details as to how to value different assets. Nevertheless, there will always be (a rather large) room for discretion – discretion which can be exercised by company management.

What happens when an asset becomes more valuable during an accounting period? The increase in value is called “unrealized gain”, and gets counted as profit in the Income Statement. What happens when management is incentivized by larger profits? And what if you combine this with management discretion in determining the value of the assets?

There is a company listed on the Australian Stock Exchange called Blue Sky. Its share price has fallen from around $12 to around $3 in April of 2018. The catalyst was a report by a hedge fund, which disputed the asset values that the company had ascribed to the assets on its balance sheet (and to asset in the funds it manages as well). While initially the company stood by its valuation, it later agreed to write down the value of its assets, and several board and management committee members have stepped down.

As an investor I’ve always had reservations about mark-to-market accounting. [Here is another gem dating from the financial crisis: the single most profitable day in the history of Lehman Brothers was the day before they went bankrupt. That day the value of their publicly traded bonds plummeted. Lower bond price, when marked-to-market, equal lower liabilities, which adds to profit.] The recent events at Blue Sky underscore this once again. I’d rather have an old number that I understand than an up-to-date number for which the basis is shrouded in mystery.