Making sense of the credit crunch fair value debate

Richard Mallett

Why watering down fair value rules could be a disastrous own goal. By Richard Mallett, technical director of the innovation and development team at CIMA.

As reported in last month’s Insight, the credit crisis has sparked fierce debate about the effect of fair value reporting in turbulent and illiquid markets.

Major companies have complained that using fair value has wiped out reported profits, or increased losses by forcing them to report their assets according to current market, or modelled, prices. The latest outburst was from private equity billionaire David Bonderman who, in an interview with the Financial Times, called fair value accounting standards ‘absurd and destabilising’. He made the criticism because of the effects that the fair value had on the worth of the debt of his companies in the current volatile financial climate.

Tim Bush of Hermes Asset Management was also reported having made some scathing comments. In a presentation, he said that IAS39, the standard that deals with financial instruments, was ‘known to be faulty. IAS 39 accounting stops at an abstraction, a “price”, with no overriding check as to what - if anything - is underpinning it…[This] is little different to the estate agent valuing a property by relying on the price of the house next door, but who may find a lower value if he was required to observe from the inside whether the house had subsidence.

In recent months, the argument has also drawn in parties such as the European Financial Reporting Advisory Group, the Institute of International Finance - which has 300 banks among its members – and financial regulators.

CIMA’s CEO Charles Tilley also joined the debate by writing a letter to the Financial Times, defending fair value. He said: 'The balance sheet is supposed to be a snapshot of the state of company’s financial affairs at a point in time... if we use average prices, it seems to me that we end up with the worst of all worlds, with reported figures becoming almost meaningless.’

Pros and cons

What are we to make of this debate and the pros and cons of using point-in-time market prices to determine a company's fair value?

So far, the focus has been on the banking sector and the large write downs and volatility caused by marking-to-market (and model) in an increasingly depressed economic climate.

Some have suggested that the solution is for Europe to move away from reporting date based measurement of the market price and instead to start measuring the average market price over a set period.

Constructive debate is always healthy, but I think it’s time we looked at the bigger picture. I’m the first to admit that the current international accounting requirements relating to the evaluation of fair value are fiendishly complicated. The chairman of the IASB, Sir David Tweedie, has quipped that if you understand IAS 39, then you haven’t read it carefully enough.

But working with the existing standards is still the only viable option if we are to continue towards the goal of international convergence, which is the overriding priority. As Charles Tilley said, the balance sheet is supposed to be a snapshot of the state of a company’s financial affairs at a specific point in time. Although there are shortcomings with the current mixed measurement model using both fair value and historic cost, in general, international standards are moving in the right direction.

Simplify

As reported in Insight’s financial reporting news roundups, the IASB recently issued a discussion paper, 'Reducing complexity in reporting financial instruments'. This is the first step in the simplification of a standard inherited from its predecessor body. The current board believes that there are too many classes of financial instruments and too many methods for measuring them. Reducing complexity in the standard is a welcome move and a better way forward than proposals to completely ignore it.

Also, the IASB has formed an advisory panel which had its first meeting on 13 June. The panel’s advice is being sought in reviewing best practices in the area of valuation techniques, and formulating any necessary additional practice guidance on valuation methods for financial instruments and related disclosures when markets are no longer active.

Worst kind of fudge

If we move towards average pricing, we will end up with reported figures becoming almost meaningless. Reporting based on an average market price is a fudge of the worst possible kind. There is the strong chance that the asset would never have hit the set price, the value recorded would be historic rather than actual and it offers little certainty as a future indicator.

Rather than turn our backs on the current method as soon as the market starts to get jittery, a better solution would be to place more emphasis on narrative reporting. The US Securities and Exchange Commission (SEC) recently advised companies to use their narrative reporting to explain more fully the particular facts and circumstances of their use of fair value. Attention is focused on the so-called Level Three fair value assessments. This category contains the most complex structured securities where values used depend on 'unobservable inputs' - assumptions used within financial models.

The SEC’s advice to companies is to disclose in their management discussion and analysis how the fair values used were determined and how changes to those values have impacted or could impact on results, operations, liquidity or capital resources. This type of narrative disclosure gives a more rounded picture and would better inform the market.

Straightforward processes

In the UK, specific advice is also given in the Accounting Standards Board’s reporting statement on the Operating and Financial Review (OFR) published in January 2006. Since the proposed mandatory OFR was never legislated for, the reporting statement remains ‘persuasive’ but is generally regarded as best practice for UK narrative reporting. The reporting statement specifies a number of principles for the OFR. One of these is that the OFR should supplement the financial statements to enhance the overall corporate disclosure.

To fulfil this provision, companies should provide additional explanations of amounts recorded and explain the conditions and events that shaped the information contained in the financial statements. So there is no shortage of advice on disclosure in this area. And if a company’s reported value of financial instruments reflects a distressed market, it’s a straightforward process for the board to make it clear that they have reasons to believe that it is not a true reflection of future potential.

This is a far more realistic approach than using average pricing where there is no guarantee that the price will return to the average in the future and more crucially, the value does not accurately reflect market movement. We await the deliberations of the IASB in this area.

The recent spate of large write downs in the banking sector is naturally a cause for concern, but banks have to take the rough with the smooth. After all, they were only too happy to benefit from fair value when the markets were buoyant. It’s only now that the economic climate is less clement that the fair value detractors start to pipe up. If organisations want to show a true and fair position, they should show the volatility in their position.

The long-term view

If you step back and take the long term view, the message is clear. To diverge from the current reporting track would almost certainly derail any further progression towards an international convergence of reporting standards.

The process in relation to the European market has already become politicised. A dangerous precedent was set four years ago when the European Commission agreed to a watered down version of IAS 39 following vigorous lobbying from the banking sector.

In April, a new procedure was adopted by the European authorities that will give the European Parliament and Council the right to reject IASB standards for use in Europe.

This move heightens concerns about the development of a European IFRS in parallel with the full IFRS standards. If the Commission yields to demands for further carve outs or even the complete restructuring of some standards in the future, we could see many listed European companies having to provide two separate sets of reports – one under IFRS and the other under 'IFRS as endorsed by the EU'.

A split in the reporting mechanism would almost certainly mean that Europe would lose out on the benefits of international convergence. Standard setting should not be reduced to a game of political football. Watering down fair value reporting might appease the banking sector in the current market climate but, in the longer term, it could well turn out to be a disastrous own goal.

The CIMA Mastercourse ‘Treasury management workshop’ will run on 8 and 9 July 2008 in London. It’s a two-day workshop, including IAS 39 implications on treasury hedging decisions.

Look out for more on accounting in the credit crunch in future editions.

July 2008 

Back to Insight front page

What did you think of this article? Email tim.cooper@cimaglobal.com.