Seismograph Bobble Causes Massive Earthquake!

Apr 3, 2009

Yesterday, a laboratory assistant in the geology department at Stanford University walked past a seismograph on a workbench, and accidentally jostled it with his elbow. The contact caused the seismograph to give a Richter Scale reading of 7.6, thereby causing a massive earthquake with an epicenter 125 miles southwest of Mexico City.

In a related development, also yesterday, the U.S. stock market rose 2.5% on news that the Financial Accounting Standards Board voted to relax the “mark-to-market” rules in generally accepted accounting principles (GAAP) governing how companies value certain financial assets on their balance sheets. This would have a particularly significant impact on the financial statements of financial institutions that are the lucky owners of large amounts of the so-called “toxic assets” we hear so much about.

How odd. How is it possible that the stock market would go bananas over a change in how companies are allowed to count the beans, when there has been no change whatsoever to the true underlying economic value of those same beans? There has to be more to this — I’m just not sure what it is.

Ever the faithful optimist, I believe strongly that investors are not stupid. Don’t get me wrong — a few really are stupid, usually on a rotating basis — but on average the market as a whole isn’t. Consider, for example, the recent GAAP change requiring companies to run the expense of stock options through their income statements. This led to a sudden and massive drop in the reported income of many public companies. But the impact on stock prices was nonexistent, because there was no new news for investors — for decades, companies had already been required to disclose extensive details about their stock options, so the financial implications of the options were widely understood whether they flowed through the income statement or not.

I suppose it’s possible that there is some sort of real economic impact related to the accounting rules for financial assets. For example, federal regulations place limitations on the amount of business a bank can do based on how well it’s capitalized, which in turn is based on its GAAP financial statements. And in some markets the price at which assets are traded may be based on their value in accordance with GAAP. Why a market would use that — rather than an assessment of the fundamental underlying economic value of the assets — is hard to understand, but stranger things have happened.

Ah, well. Let’s just remember that business reality and accounting reality are not always the same thing.

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