'Fair-Value' Accounting Isn't Fair

Being an accountant by trade, I’ve had some thoughts about how the recent spotlight on ‘fair-value’ accounting has been affecting the markets. Essentially, fair-value is a set of accounting principles that reflect financial statement items at current market prices rather than historical cost prices. The entire world’s accounting standards are moving towards fair-value presentation. The basis for this is that it provides more current figures and gives investors more transparency into the health of the company, while original prices may be outdated and no longer relevant for users.

They are right, and absolutely wrong.

Although fair-value accounting should be implemented for increased reliability in financial statements, there should be a limit to the pressure fair-value puts on companies. The perfect example is American International Group Inc (AIG). This American giant was forced to write down $4.88 BILLION worth of assets to then-current trading prices to accord to fair-value accounting. Not only did this massive write-down send the stock to the bottom of the ocean, it also cried out for a more reasonable approach.

Personally, I do believe that fair-value accounting should be implemented. It’s much more adapted to today’s dynamic business environment than historical-based accounting. However, when the markets are frozen and illiquid, writing assets down to fire-sale prices is completely ridiculous. Just because the assets may be worth pennies on the market does not mean they do not provide value to the firm itself. Especially with the newly found volatility we have been experiencing lately, these could just as well go back up in value once the economy recovers. Unfortunately, write-ups are practically never made in accounting, so AIG is likely stuck with its completely destroyed balance sheet.

My take on it: auditors and accountants that sign off on public statements should be given protection against being sued if the company goes bankrupt. It is rarely their fault, but signing off on written-down statements like AIG’s and causing a company bankruptcy can easily lead to the auditors carelessly being sued.

More importantly, FASB, AcSB and other accounting bodies have been too rigid in their fair-value accounting requirements, and although the rules will lead to new international standards, they need to be worked on to be more flexible.

Comments

[wakeup call:]

Mark to market (fair value accounting) makes no sense for longterm hold investments. The current crisis in the financial markets is a case in point. If you look at the make to market valuation on collateralized debt obligations(40-50% of face value) versus the default history of the underlying loans (approx 10%) artificial liquidity squeezes occur placeing pressure on companies even where no real losses have or are expected to occured. The valuation of the CDO are more reflective of gun shy rating agencies overreacting to market trends to protect themselves from litigation rather than giving a true value of a particular investment. In a November statement issues by Ben Bernanke he advocated continuing with mark to market valuation for the private sector but once the Feb purchased "bad loans" they should be valued on a hold to maturity basis. The would have forced the private sector to convert paper losses into real losses while the Government would be able to record a paper gain. MTM accounting is fine is you go to your local bank and take out a loan against the value of a traded stock. This protects the bank from taking market risk. For a company which has an investment in a synthetic security (CDO) to be forced to re-value that investment on a daily or quarterly basis without regards to the performance of the underlying loans simply injects a degree of volatility which benefits no one. Much of the current probelms in the financial markets would be eliminated if MTM accounting were eliminated. Why deal with a synthetic problem which reflects perception rather than dealing with the individual loans when and if they become problems?

2008 Dec 22 08:23 AM

[Tom Armistead:]

Fair Value Accounting, as practiced today, gives the hysterical market fears precedence in determining value and earnings. Appropriate accounting should require management to furnish their best estimate of the economic value of assets and earnings.

As an example, many MBS or CMBS assets are perfomring, yet companies are required to write them down to fire sale prices. There are databases and software programs available to develop a discounted value of future cash flows from such instruments, based on the actual performance of the underlying assets, and they almost uniformly develop a higher value higher than the market price.

I believe that balance sheets should reflect the DCF value of such assets, and disclosures should include the assumptions used to drive the models. Footnotes should also include the market value, because that information is relevant to assessing liquidity risk.

Mark to market accounting has in point of fact exacerbated liquidity risk, as it creates apparent deficiciencies of regulatory or rating agency capital for perfectly solvent companies, Because of this, regulators and raing agencies should be required to rely on DCF asset values for bonds and similar assets.

Based on these issues, mark to market should be relegated to a footnote, available primarily to permit the analysis of liquidity risk.

2008 Dec 22 08:34 AM

[Duude:]

I can't agree more. I agree with the concept of fair-value accounting but realize that it is a far too crude system when faced with temporary liquidity issues. Should companies be forced to write down assets and suffer the body blow of a credit agency downgrade that results forcing a company to raise capital through the markets or selling assets into an illiquid market to save their rating? This is nuts! I can't believe we haven't yet amended fair value accounting to address this problem. This isn't about sweeping it under the rug, nor should a fix enable that to occur. There has to be an existent stipulation that should market liquidity dissipate to a predetermined level, that a secondary option of value using cash flow to maturity analysis but with an eye on ratings would be available.
Imagine if mortgage holders had the right to call back a loan if their equity dropped to a predetermined level, much as margin works in the stock market. In today's real estate market, a lot of people would be getting margin calls. Now they either need to bring more capital to the table or sell their home in the current market, without any consideration given to whether you're paying your mortgage on time. How crazy is that? How may more homes would go into foreclosure? What's the benefit here?

2008 Dec 22 02:14 PM

[Gtarras:]

Great stuff. Not enough of it out there.I have been arguing with colleagues about it a lot. My issue is that not many people get that. Not because they are stupid, its just not their area of expertise. I build models. I know that when you plug-in "fear market" assumptions (already horribly skewed) into CDO or ABS model, you get "fear squared" or even "cubed" out of it.. How bad is that? Really bad... This way you scare a hell lot of people... and guess what? Finance is all about trust...When you scare people, there is no trust to speak of.. Think Lehman and Bear... And Citi...

About accountants and auditors.. Its their azzes on the line.. Do you think they will force you to be more or less conservative? and so this is what we get.. scared public, which is clueless how the write downs are calculated.. but hey, auditors signed -off on them, right? yea.. do you think they have a clue themselves? they are not stupid, no... i have no clue about most of what they do... but, i know they dont fully get it, and force you to make it look even worse that "fear cubed"... and try to argue with your auditor...

2008 Dec 22 04:04 PM