The bigger picture

With financial markets in turmoil, banks and insurers are forced to report significantly lower values for their assets. In such times, is fair value accounting fair? Richard Young weighs up the pros and cons

When it comes to complex financial products such as derivatives and collateralised debt obligations, the notion of fair value - otherwise known as 'mark-to-market' - accounting is the subject of bitter debate. Accounting standards require entities to report the value of these assets not on their purchase price (the 'historic cost') but on what they're worth on the balance sheet date.

But with financial markets in turmoil, the value of many of these complex instruments has plunged. 'Financial instruments are usually traded in active markets with reliable prices - so fair value is much more relevant than historic cost,' says Peter Holgate, senior technical partner at PwC. 'But things get complicated when the market is much less active and the pricing mechanisms start to break down.'

Once-liquid markets have dried up, leaving prices in a slump because there are so few buyers. Until those markets pick up, companies are having to write down assets and take massive hits to their income statements. In May, for example, the holding company of US municipal bond insurer MBIA Insurance Corp posted a quarterly loss of US$2.4bn - caused by a pre-tax loss of US$3.6bn taken on credit derivatives that it insures, reflecting the net present-value basis of the losses it expects to pay.

The European Financial Reporting Advisory Group (EFRAG) and the Hundred Group of Finance Directors are among many bodies that are critics of fair value. In EFRAG's letter to the IASB last year, for example, it argued that the really useful information is an entity's cash flows, not some notional disposal price of various assets it holds.

Not that the financial institutions are getting much sympathy from the accounting regulators. 'The noise for removing fair value is largely coming from preparers of accounts,' says John Smith, board member of the IASB and former Deloitte partner. 'But they made these investments and are responsible for managing the risks. Now some of them have problems, and quite understandably they don't like reporting bad news. But regulators and investors want the fuller picture that fair value gives them.'

Volatile prices

But dramatic moves in the market - or even the de facto collapse of some markets while the credit crisis grips the financial sector - are largely temporary, argues the anti-fair value lobby. To report point-in-time asset values based on highly volatile markets paints a misleading picture.

That's not how the regulators see it, of course. 'Entities must manage the risks associated with these instruments, even if they're not performing as the management expected they would,' says Smith. 'The volatility they have to report is real.'

Holgate agrees: 'Do you decide that volatility makes fair value too difficult to use? Or do you accept that you own assets in a volatile market and that reality is reflected in the accounts? That's got to be a more useful interpretation than simply giving up and returning to a report containing historic costs.'

The other major argument against fair value is that when there's no market to mark against, pricing for assets becomes rather… theoretical. Complex modelling of asset values might be a great way for mathematics PhDs to earn a crust, but it's no more related to 'true' value than historic cost. The ASB itself questioned 'the assumption that fair value should always be equated with exit value' in a draft report issued in March 2007, before the current turmoil even began.

The IASB has acknowledged that this can be a grey area. 'Our measurement project focuses on the quality of the information used to make the estimates,' says Smith. 'It requires that you use the best information available, including actual transactions, when there are no active markets. Yes, that's subjective - but it's no different from the treatment of a bank loan where the borrower is defaulting and the bank has to make an impairment assessment.'

The opponents of fair value argue that investors and regulators would get a more complete picture if there was some kind of averaging system in play. Work out the long-run, smoothed average price of the assets and report that instead, they say.

Accountants loathe the idea. 'If there is a market - but one where prices are unusually low for the assets - that's even trickier,' says Richard Martin, ACCA's head of financial reporting. 'Do you try to foresee a recovery? Should you apply an average price over time? How far do you go back? In fact those options seem to make less sense - either way, you're choosing to ignore the most recent pricing.'

Investor confidence

For investors, the situation could best be described as confusing. 'Our members like to value their portfolios with reference to markets,' says Michael McKersie, assistant director for Capital Markets at the Association of British Insurers. 'But above all, they want to understand what the real situation is for any given company. That requires assets and liabilities to be valued on a consistent basis.'

His concern is that with different valuation methods allowed by the standards - including complex hedge accounting - it's difficult to assign hard balance sheet numbers to assets that in reality have uncertain value.

In a sense, the broader problem is how a point-in-time balance sheet - and the resultant gains and losses in the p&l - can ever be said to be 'accurate'. 'You can't incorporate into balance sheet values all of the characteristics of an instrument that users of accounts need if they're to understand whether values are high or low,' says McKersie. 'As long as people interpret point-in-time balance sheet information in an appropriate way - and factor in both the market's periodic irrational exuberance and its depressions - things don't look quite so severe.'

That's why the most realistic solution for companies trying to maintain the confidence of their investors is to talk to them. A lot.

'The best response to the problem with complexity in fair value models - and with fair value full-stop - is to say exactly what it is that you've done,' says Martin. 'Be clear about what's modelled and what prices are based on markets. There are some issues for auditors that can't entirely be dealt with using such extended disclosures, but more clarity in reports can only help.'

'The onus is on preparers to communicate better,' says the IASB's Smith. 'The Institute of International Finance, a global association of banks, has recommended moving off fair value in some circumstances - but only if additional disclosures are made to clarify the situation for users of accounts. Well I would argue you can keep fair value - and make those disclosures to explain what's happening.' The IASB is now looking into best practice for the kinds of disclosures increasingly being seen in 2008 reports to see what could be incorporated by entities more broadly.

Future for standards

But even the IASB admits that IAS 39 - the most high-profile and contentious standard for financial instruments - is over-complex.

To some extent, that's inevitable. 'It's partly a result of having both historic cost and fair value requirements for different assets, as well as some situations where the preparer has a choice,' says the ACCA's Martin. 'But much of the complexity derives from the fact that the instruments they're designed to handle are themselves extremely complicated.'

In fact the most likely revision to IAS 39 - which could happen by 2009 - is that all the historic cost measures will be removed. 'That would be a major simplification, although implementation might be problematic for companies,' says Holgate. 'You do have to weight up the complexity of the standards *and* the complexity of implementing them.'

And the ABI's McKersie adds that, although the consultation on reducing complexity in IAS 39 is laudable (responses are due in to the IASB by September), no solution will be perfect. 'That's one of the problems with fair value: because it's not transaction-based - as historic cost is - you can't state that it's "true",' he says. 'But neither is historic cost; it's impossible to say that either is objectively superior to the other. And inevitably, you lose something when you move from one to the other.'

No end in sight

The IASB's Smith says change is coming: 'What is needed may be further enhancements to the measurement of fair value in illiquid markets, additional disclosures and improved regulations for accounting of investments in off-balance sheet special purpose vehicles - and we are addressing those issues.'

The question investors ask is, which approach is more useful? What's more reliable and consistent over the long term? 'Mark-to-market fails if you can't rely on liquid prices over time,' says McKersie. 'So while we might see less angst in the fair value debate if markets pick up and become more liquid for these types of instrument, that won't mean that the problem has gone away.'

Despite these apparent complexities and the criticisms levelled at the current use of fair value, it doesn't appear to be going anywhere. 'Fair value may not be perfect, but it's the best we have,' Martin concludes. 'And users wouldn't thank us for allowing over-optimistic value in accounts. Markets fluctuate and at any given time prices for certain assets might be in bargain territory. But the market is what it is.'

'That's the point of accounting,' says Holgate. 'You'd rather be approximately right than exactly wrong.'

It's not just investors…

Investors looking askance at reported losses aren't the only problem with fair value and volatility. 'The decisions of financial services regulators will be based on the numbers reported using fair value,' says the ABI's Michael McKersie. This has already caused problems for some banks facing capital adequacy tests. 'And debt instruments, for example, will have covenants on interest cover that will be triggered by changes to the market or reported values.'

The ratings agencies - whose decisions on creditworthiness can fundamentally alter a company's ability to operate - are also in play. In a recent survey of directors and lawyers working for financial services firms conducted by Eversheds, two-thirds of respondents laid blame for the credit crunch at their door, partly because they failed to tackle optimistic 'fair value' assessments on products such as collateralised debt obligations. Hardly surprising, then, that they're merrily downgrading the quality of assets for many financial services firms now.

And auditors are also facing an uphill battle in interpreting the fair value standards as they apply to client accounts - particularly where values are based entirely on subjective financial modelling.

Even in the midst of all this upheaval, the regulators are staunch in their defence of fair value. 'Yes, the issue at the moment is very much driven by the credit crisis,' says the IASB's Smith. 'But in times like this, investors' confidence in the market is crucial. And if we said you don't have to use fair value any more, we would introduce even more uncertainty into the system.'

He argues that the turmoil in financial markets has, in fact, been at least in part assuaged thanks to the discipline imposed by mark-to-market valuations. 'Because companies have been using it, many of the problems we're now dealing with were identified much earlier,' he says. 'Its use may have prevented the problems from growing outside the gaze of regulators and investors.'

Richard Young is a freelance writer and editor, and former editor of Real Finance. 
Email: Richard.young@gmail.com