George M. Mangion | Wednesday, 08 April 2009

Reforming “Fair Value” accounting

Without any doubt the concept behind Fair value accounting does have its weaknesses and in light of the number of bankruptcies that have of late hit banks it is not a moment too soon to see whether as unfairly quoted it can be blamed for such a bad state of affairs. This has recently led to a review process that I shall be commenting upon in this article. To what extent such a review will improve financial reporting and the resulting change it will bring is anyone’s guess but certainly it is here to stay. The days of cost accounting are dead and buried.
Here I can quote the results of a study conducted by three experts on the subject that solidly proclaim that while “fair value accounting“ has been under strain particularly when used in banking circles it still has a longer lasting value when compared with “historical cost“ accounting. This was the conclusion drawn by Professor Hillier who worked on the study alongside Leeds colleague Dr Iain Clacher, Alistair Byrne of the University of Edinburgh and Allan Hodgson from the University of Amsterdam. Professor Hillier said: “Proponents of fair value accounting argue that historical cost obscures the true underlying economic position of the firm, whilst cynics believe that the transitory nature of fair value injects unnecessary volatility in financial reports. Thanks to a recent reform in US GAAP rules banks can now transfer assets from the trading category to the “available-for-sale” or “held-to-Under maturity” category. This concession has the advantage of extending any severe drop in value over a period during which it is amortised. Back to Europe, under IAS 39, companies can now reclassify securities out of the trading “in rare circumstances”. Stated briefly one can explain that this allows a company which both intends and has the ability to hold loans for the foreseeable future, or debt securities until maturity, can permitted to reclassify to a cost basis. Here it is opportune to quote Sir David Tweedie, IASB chairman, who made it clear there was a political imperative to the move. This is particularly relevant when one considers in detail the heavy fall in values of bank assets who were recently badly inflicted by toxic debts in the fallout of the sub-prime crisis. Another difficulty is certainly that dilemma which faces preparers of accounts in trying to distinguish between market data, which is indicative of fair value, and market data which relates to “fire sale” values achieved in a distressed or inactive market.
IAS 39 can be used to illustrate the potential impact of the use of fair value upon a financial institution’s performance. Clearly under past rules, if a bank trades in options as a way of generating profit, IAS 39 requires that the options are included in the balance sheet at their ‘fair value,’ which is defined as the market exit (selling) price. Any change in the fair value of the relevant assets or liabilities over the accounting period is then taken through the income statement. For a number of years this proved to be a consistent manner of how any sudden change in value can be captured and consequently properly reflected in the income statement. Critics of this methodology particularly under the influence of a severe recession lament that it changes the nature of the income statement because net income before tax may now no longer be a consequence of the bank’s economic activity. In times of rising stock market indexes this meant that banks will as a result recognise a surplus arsing purely out of an increase in the fair value of assets. In other words, in a rising market that we experienced up to 2007 before the onset of the credit crunch in September 2007 then the positive changes in market values did lead to a substantial improvement in the reported results. No doubt this in turn helped push up share values and in the process did cloud the issue whether banks have truly performed well due to usual core business or because of external (market) reasons. Another issue associated with the working of the “fair value “method is the inherent difficulty associated with assessors of market or saleable values of assets when in some circumstances such a market does not exist. Of course, experts can be expected to simulate a value in such an occasion but in all probability this may end up to be a subjective estimate. It is not surprising to note that finding a willing buyer for a particular asset or estimating its price following the sudden collapse in the US of the packaging collaterised securities on mortgages is a challenge. Thus when asked to arrive at a fair value of such collaterised debt offerings at a time when buyers burned their fingers so badly with such instruments have backed away from risks associated with opaque investments such as these. We have witnessed how, in many cases, the price tags dipped to artificially low levels, forcing banks and insurers to take large write-downs and simultaneously raise capital to shore up their balance sheets. It goes without saying that banks never really intended to sell such assets unless forced to do so if a government made it a precondition to bail them out. The words of Sir David Tweedie, chairman of the International Accounting Standards Board sound prophetic. He was quoted recently as saying that “the credit crunch isn’t an accounting problem. It’s a banking problem”. Nevertheless, the chairman has been an outspoken critic of the very complex IAS 39, the main accounting standard behind fair value accounting for financial instruments. The complexity of implementing IAS 39 increases when embedded derivatives need to be valued. Thus when an entity becomes party to a hybrid instrument that contains an embedded derivative, IAS 39 requires the entity to assess whether to recognise the embedded derivative separately from the host contract and measure it at fair value.
As stated earlier IASB is revising IAS 39 which should make the rules simpler. On 5 March 2009, the IASB issued amendments that require enhanced disclosures about fair value measurements and liquidity risk. Among other things, the new disclosures help clarify that the existing IFRS 7 fair value disclosures must be made separately for each class of financial instruments. Secondly it makes it imperative to give better disclosure of any change in the method for determining fair value and establish the reasons for the change while it now establishes a three-level hierarchy for making fair value measurements. The amendments now clarify that the current maturity analysis for non-derivative financial instruments should include issued financial guarantee contracts. Better disclosure is expected in case of a maturity analysis for derivative financial liabilities. However, there is no magic bullet as much of the complexity of the standard is derived from the hybrid qualities of the financial instruments it is addressing. In my opinion, what may be required in the future is further improvements to proper measurement of fair value in a global recession when markets have seen unprecedented drops in values. The solution is a complex one since the underlying assets which have graced off-balance sheets investments call for smarter regulations. Certainly when things go bad it is easy to start pointing fingers looking for convenient scapegoats. The sudden collapse of banks in the international arena has shaken investors confidence and something must by done by regulators to help restore it. It is easy to blame the fracas to a mishmash of greed leading to excessive leverage achieved by collaterised debts linked with the securitisation of toxic assets. All this leads to the turmoil of the markets and not the judicious use of “fair value “accounting. Obviously during such turbulent times, it is becoming important for management to explain the context and consequences of reporting fair value.
Let us stop blaming “fair value“ accounting as the framework responsible to have fanned the fire resulting in the fall out of global markets in this credit crisis.

George Mangion
Partner at PKF – an audit and business advisory firm



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08 April 2009

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