Another Accounting Law Designed To Increase Transparency Does The Opposite

from the unintended-consequences dept

With all of the financial mess out there, it's likely that we'll soon see calls for new regulations to help "protect" against fraud. However, before we rush into doing so, it's worth looking at how damaging previous attempts to do the same thing have been. We've already covered the massive amount of damage done by Sarbanes-Oxley, which basically made it extremely difficult for a private company to go public and significantly increased costs for any public company -- all while doing next to nothing to actually cut down on fraud.

And, now, FAS 157 has come into play -- a new rule impacting many venture capitalists, forcing them to figure out what the "fair market value" of their investments are, and provide that number to their investors. This has many different VCs complaining about what a stupid process this is. It raises similar questions as the legal change a few years ago that required companies to put stock option valuations on their books as well. The problem is that these things are impossible to accurately value. Not difficult, but impossible. You're asking people to value a totally illiquid asset as if it were liquid.

Even if the venture capitalists use a rigorous process, the result will be wrong. There's simply no way to accurately value something like a private startup until another transaction happens where the value is actually set. And, that's the way it should be for a private investment (it's also why not everyone is allowed to invest in such endeavors, because it is inherently more risky). But forcing companies to make up bogus (no matter how well meaning) valuations for companies has dangerous unintended consequences. No matter how bogus the numbers are, since they're there, people will use them as if they're real. And that will lead to more bad investing, rather than less. So, once again, we have a law designed to stop bad investing, which will most likely cause the opposite to occur.
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Filed Under: accounting, fas 157, regulations, sarbanes oxley, unintended consequences

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  1. identicon
    Laurent GUERBY, 23 Jan 2009 @ 3:56am


    There's no problem in having prices for options on traded stocks (unless the stock itself isn't liquid), there's a actually a fully public market for those in most countries. I worked for ten years in this area.

    So it's not true it's "impossible" to value them, the prices are available and just as good as stock prices when the stock is liquid.

    Of course if the stock is not liquid, there's no good stock price and no good option price so in this particular case (startups included) it's indeed impossible to have a good price for both stock and options.

    One side note on this debate: while privacy-like protection might be commonly accepted for accounting information about private firms which make public only limited agregated data, since we're talking about more or less direct nationalization of some parts of the economy it would be good to remind the public and politicians that there's no good reason at all in the internet age with near zero publication cost not to have fully detailed accounting information on public entities, down to each purchase and each valuation of each asset.

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