Accounting: It's a fair cop

Ever since the credit crunch froze the global financial system there has been
a persistent theme of blame: shoot the messenger. The messenger for this
particular purpose is the financial reporting system. And, more specifically,
that means fair value reporting.

Charlie McCreevy, the European commissioner for the internal market and
services, recently put fair value reporting in his sights. He claims one of the
responses to the global financial turmoil should be to improve valuation
standards for complex financial instruments, particularly given the extended and
significant use of mark-to-market and mark-to-model valuation methods. McCreevy
says a better way has to be found of valuing financial assets when market
liquidity is poor to non-existent. In particular, he wants improvements in
disclosure standards in the securities market, since inadequate pricing and
valuation exacerbates uncertainty about the size and location of risk in the
securities market.

Standard setters have long rejected the idea that the concept, practice and
use of fair value fuelled the flames of the credit crisis. But Sir David
Tweedie, chairman of the International Accounting Standards Board, introducing a
discussion paper on reducing complexity in reporting financial instruments, said
that a poor understanding of the risks involved in using complex financial
instruments has been a contributing factor.

Sir David argues that fair value has a disciplining effect on an
institution’s lending and investing decisions – mostly on the grounds that,
unlike historical cost accounting, users are not lulled into a false sense of
security. And even if the global financial system had been reporting under
historical costing rather than fair value, the system of impairment principles
would still have ensured eye-wateringly hefty write downs. Under fair value
accounting, assets must be priced to the market price; in other words, what they
would be expected to fetch if sold today.

The fear raised by regulators such as McCreevy is that the mark-to-market
approach is helping to turn a liquidity crisis into a potentially even more
serious solvency crisis. As banks revalue their assets at rock bottom prices
they are running short of capital, forcing them into fire sales and further
write-downs. Quickly, a vicious circle is established that is as irrational and
unrealistic as the exuberance exhibited by markets before last summer.

It would be a brave supporter of fair value who claimed the system was
perfect, but its defenders say it is the least bad. The weakness is that when
markets collapse prices become unreliable because there is barely any market in
which to find a price. But fair value is meant to represent a reasonable value.
It is not meant to be some absolute truth. And pricing should never be mistaken
for an exact science.

In other words, when using fair value, the exercise of sober judgement is as
important as what the flickering figure on a screen may be telling you. This
crucial idea is expressed by the IASB’s and the US Financial Accounting
Standards Board’s statements on fair value measurements which – with delicious
irony – were finalised last autumn when the severity of the credit crunch was
revealing itself. Clearly, every FD has carefully read the IASB’s 97-page
document on the subject and will, therefore, recall the idea of Levels 1, 2 and
3. Level 1 is about assets that can be marked-to-market, where an asset’s worth
is based on a real price, such as a stock quote.

This gets a lovely, confident tick mark – and is the equivalent of kicking
the tyres as you do the stock take.

Level 2 is a mark-to-model: this is a best estimate based on observable
inputs which should be used when no quoted prices are available. At this level
it is possible to get the price on several bids and find the average, or
alternatively it should be possible to base the price on assumptions and
knowledge of what similar assets sold for.

And so to Level 3: here, values are based on unobservable inputs reflecting
co mpanies’ own assumptions about the way assets would be priced. This is the
territory only really inhabited by the most studious of spreadsheet jockeys.
Even so, it should be possible to produce valuations that would satisfy the
McCreevy test of being less opaque and the Tweedie test of being based on
discernible principles that reflect economic realities and increases
transparency for all users. At its best, accounting information should reflect
economic and commercial reality.

But the problem with solving this crisis is not, in the end, about
accounting. Rather, it is about a more precious commodity than even fair value:
confidence. If the banks don’t trust each other enough to lend to each other,
why should anyone else trust the valuations that these entities are placing on
the assets they hold? Level 3 valuations are widely seen as nothing less than
wild guesses. Such cynicism goes to the root of the present problem, and deeper.
If we don’t trust the figures then we lose confidence – not in the financial
reporting system, but in the entire financial sector. Improving financial
reporting may be one vital ingredient, but it is nowhere near the whole answer.