Beware Bean Counters' Changes

By PETER EAVIS When an accounting rule is loosened, it is worth tracking which companies profit soon after. Facing pressure from many banks and members of Congress, the Financial Accounting Standards Board, the U.S. accounting rule maker, voted on Thursday to ease certain asset-valuation rules. One change makes it easier to keep certain losses on securities out of earnings. Another allows companies slightly more leeway in valuing assets that don't trade in active markets. Investors who care about transparency of financial statements can feel somewhat relieved that the changes didn't turn out to be large. Banks still will have to try to place market values on assets, including toxic securities that trade at low prices. But extra vigilance is required now that financial firms can place more emphasis on valuations arrived at with internal models. Some of the biggest corporate blowups of the past 20 years, like Enron, occurred chiefly because managers could exploit accounting rules that gave them great liberty in pricing assets. What should investors look out for as banks and insurance companies issue financial statements under the tweaked rules? First, under the new guidance, companies have to state that they have changed their valuation techniques, and possibly explain the impact. Any vagueness in those disclosures -- like a failure to say exactly how much earnings and capital have been affected -- would be an immediate red flag. Second, investors should focus on disclosures on what accounting rules call level 3 assets, where the valuation relies overwhelmingly on internal models. Since markets are so illiquid right now, some assets may end up being reclassified as level 3 assets. Partly for that reason, the amount of level 3 assets on firms' balance sheets may go up. That growth isn't necessarily a danger sign. For instance, broker-dealers like Goldman Sachs have a relatively high percentage but have been strong advocates of applying "mark-to-market" accounting. What investors should watch for are changes in unrealized gains and losses in level 3 assets. Theoretically, management's own calculations will carry more weight. Monitoring changes is particularly important where unrealized losses are large. For instance, Bank of America had a hefty $12.14 billion of unrealized losses on level 3 assets at the end of last year. Any big reduction in that loss could boost capital, for instance. PNC Financial Services Group, which called for mark-to-market rule changes, may be another bank to watch closely. The bank's tangible common equity, at $5.82 billion, amounts to just over 2% of its assets, which is low compared with peers. That figure reflects unrealized losses on securities of $3.6 billion. If those losses were to diminish, the positive impact on capital could be particularly pronounced. Granted, many of those losses are on securities that trade in active markets, but the bank holds $4.84 billion of level 3 securities in its so-called available-for-sale portfolio. Investors will need to pay attention. Write to Peter Eavis at peter.eavis@wsj.com