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The fair-value fall-out. By Rob Lewis
Growing liquidity problems, and a recent re-think at the IASB, suggest the tide seems set to turn for fair value and mark-to-market accounting. Many of the financial institutions and accounting firms that championed its cause in the growth period are exhibiting waning enthusiasm now that assets cannot be easily divested.In the US, American Insurance Group (AIG) was the first public company to come out and criticise fair value after a record quarterly loss of $11 billion following a mortgage write-down. Last week, AIG’s chief executive, Martin Sullivan, complained that the group had no intention of selling its assets at the current prices. He argued that the current rules created a vicious circle in which companies incurred paper losses, lost the confidence of investors, and then had to raise funds in unfavourable market. Lehman Brothers and Goldman Sachs also experienced write-downs of $1.8 and $2 billion respectively.
The Financial Accounting Standards Board (FASB), which is responsible for setting US accounting standards, and the Securities and Exchange Commission (SEC), declined to comment. American politicians have been more forthcoming. Barney Frank, chairman of the Financial Services Committee in the House of Representatives, has also asked for the fair value rules to be reconsidered.
In the UK, fair value critics have been vocal for some time. In March 2007 fair value caused an unusual breach of solidarity between its chief advocate, the International Accounting Standards Board (IASB) and the Accounting Standards Board (ASB). The ASB issued a draft report that called several of the IASB’s fair value’s proposals into question, particularly “the assumption that fair value should always be equated with exit value”.
Doubts on fair value did not diminish as the year went on. The Financial Stability Forum, comprised of senior representatives from various finance ministries and institutions around the world, attempted to address inconsistencies of implementation in September. In November, the former governor of the Bank of England, Lord Edward George, warned that fair value was adversely affecting market confidence. A month later, ratings agency Fitch published a report that highlighted further problems.
The anxiety that fair value could act as a secondary catalyst for illiquidity, and ultimately insolvency, is such that several unexpected participants had weighed into the debate.
The Financial Services Authority (FSA) appears to have expanded its remit into financial reporting territory when it held a recent series of round table talks with the banks. It has been looking at the issue of market-induced downward valuations since last year, and has implicitly criticised the fair value concept, even reminding bankers they are free to divert from it for operational purposes.
“The FSA has noted that accounting standards for financial statement reporting do not generally permit banks to make prudent valuation adjustments,” it said. “There may be a divergence between what is required for valuations included in financial statements and what needs to be considered under the prudent valuation principles laid out in Basel Two [the 2004 international standard for banking regulators].”
Similarly, the Global Public Policy Committee (GPPC) seemed to be doing the IASB’s job for it when it released a paper on determining the fair value of financial instruments “in current market conditions” in December.
“Interpreting IFRS is the responsibility of the IASB,” the report says in its introduction. Nevertheless, it does go on to offer its own guidance, although many key definitions remain problematically vague. While it reiterates that IAS 39 allows for an alternative valuation technique to be used in the absence of an active market, deciding when and what markets are inactive seems likely to be a subjective and inconsistent process. Furthermore, such valuation techniques will of necessity be more complex than the old cost accounting method or the fair value system they are intended to temporarily substitute.
The GPPC report coincided with a very similar paper issued by the US Centre for Audit Quality, dealing with the fair value implications of FAS 157 under US GAAP. The GPPC consists of the six largest accounting networks (the Big Four, Grant Thornton International, and BDO International), and PricewaterhouseCoopers is a major partner in the Centre for Audit Quality.
All these firms have historically provided substantial funding to the IASB, which has advanced the case for fair value since its inception. Sir David Tweedie, the IASB chairman, has been an open supporter of fair value for over ten years. In the UK, he finally gained the upper hand over cost accounting in 2005, when IFRS came into force for UK corporations.
The recent criticism of fair value from bankers and insurers, together with the interjections of the FSA, appear to have finally drawn a response from Tweedie yesterday when he announced the IASB was to issue a discussion paper on the relevant standard, IAS 39. But the chairman has been publicly critical of IAS 39’s unnecessary complexity for over a year without doing anything about it.
“I have long given up asking my colleagues to explain this one,” he told a conference of Australian accountants in Melbourne over a year ago.
Now that national economies may be at stake, reforming fair value has ascended the agenda. To what extent it will survive in its original incarnation remains to be seen.
Potentially, the IASB may itself suffer from the fair value fall-out. Considered an unstoppable force as recently as six months ago, the discussion paper on fair value may signal a loss of momentum. For some time, critics of convergence have argued the IASB was setting out international standards without first establishing consistent, international frameworks - consider the European Commission’s decision to defer IFRS 8 last year. Reconsidering fair value could be seen to bolster this line of thought, and worse, it could come as too little, too late if further write-downs trigger greater turmoil.
It may be of some significance too that the IASB entered 2008 £3.5 million short of its annual budget. While the IASB budget is comparatively modest compared to other regulators and standard setters, securing the remaining funding could prove difficult if cash-strapped financial institutions no longer see anything to gain from fair value now that the downturn has kicked in. Or, indeed, from advancing a system of standards that some see as partly responsible for the market’s instability in the first place.
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AccountingWEB.co.uk 20-Mar-2008
Categories: Financial Reporting Features
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Since the above article was posted, the European Financial Reporting Advisory Group (EFRAG), the Hundred Group of Finance Directors, and Royal London Asset Management have all come out as open critics of fair value.
Those opposing fair value in these circumstances do not seem to articulate an alternative for the likes of banks.
Don't forget that the "cost" model is lower of cost and net realisable value. In the current situation, the banks hold many instruments below their cost, and so would end up with similar write downs as under a fair value model.
