Fun with financial statements: watch those mark-to-market earnings numbers!

I swear I am not making this up…

The Financial Accounting Standards Board… last September approved a new, three-level hierarchy for measuring “fair values” of assets and liabilities [which can show up in earnings numbers, depending on how companies choose to express their financial statements], under a pronouncement called FASB Statement No. 157…

Level 1 means the values come from quoted prices in active markets. The balance-sheet changes then pass through the income statement each quarter as gains or losses. Call this mark-to-market.

Level 2 values are measured using “observable inputs,” such as recent transaction prices for similar items, where market quotes aren’t available. Call this mark-to-model.

Then there’s Level 3. Under Statement 157, this means fair value is measured using “unobservable inputs.” While companies can’t actually see the changes in the fair values of their assets and liabilities, they’re allowed to book them through earnings anyway, based on their own subjective assumptions. Call this mark-to-make-believe.

“If you see a big chunk of earnings coming from revaluations involving Level 3 inputs, your antennae should go up,” says Jack Ciesielski, publisher of the Analyst’s Accounting Observer research service in Baltimore [and one of the world experts on accounting gimmicks]. “It’s akin to voodoo.”

Pass me the bloody entrails…

I don’t want to pick on any particular companies, at least not yet, but follow the link below if you want to read about how a certain large bank whose name rhymes with Shmells Shmargo just reported $2 billion in Level 3 mark-to-market earnings. It will be absolutely fascinating to see how many other financial institutions start to do the same thing.

Via Bloomberg, your new leading source of entertainment journalism.