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Why we need fair value

2 Mar 09

Fair value accounting is not the cause of the financial crisis we are in, says Hugh Shields, and without the transparency that it provides, the present difficulties could go on even longer

by Hugh Shields

In recent months, fair value accounting has come under intense scrutiny from politicians, the media and other commentators. Specifically, it has been argued that the use of fair values in accounting for some financial instruments is a contributory factor to the credit crisis. Several commentators have noted that fair values exacerbate market volatility by emphasising peaks and troughs and thereby influencing economic behaviour. It has also been argued that fair values are not relevant when there is little market activity and that the current low prices do not reflect the intrinsic or fundamental value of the instruments. For these reasons, there have been calls for fair value accounting to be suspended. What are we to make of all this?

A useful starting point is to recognise that accounting is merely a language, the language of business. Like any language, it enables us to communicate and understand – in this case the economic effect of financial instrument transactions. Its role is thus to reveal rather than to drive the underlying economics. Now the peaks and troughs that we observe in economic cycles have been present for as long as there have been booms and busts. Markets always overshoot in both directions – but it is human behaviour and market psychology that are at play rather than accounting requirements. Fair value accounting simply tells us what this implies for asset valuations.

What about the argument that fair values are not relevant when there is little market activity? There are two important points here. Firstly, from a technical point of view using International Financial Reporting Standards (IFRS), distressed sales in thin markets do not count for the purposes of establishing fair value generally. As defined by the International Accounting Standards Board, fair value is the exchange amount between “knowledgeable, willing parties in an arm’s length transaction”.

Secondly, it is important to realise that the IFRS definition says nothing about whether the market is efficient and/or is correctly ascribing “fundamental” value in some way. In an IFRS sense, fair value is simply today’s market price. That is highly relevant for investors, especially those concerned about the current economic position of the company in question. In any event, it is difficult to see how one can base financial reporting on a theoretical view of the world which does not exist in the market. Who decides what is theoretically correct and where does it all end?

There is a fundamental matter which should be addressed and that is the interplay of accounting and regulation in the financial sector. There is no question that the unmoderated use of fair values for regulatory capital purposes has had an adverse, procyclical effect on the banks. As fair values have fallen, so banks have had to hold more capital against them under capital rules. That has put pressure on banks to sell the assets, to avoid the prohibitive capital consequences. This does not mean the accounting is inappropriate. It means – if financial stability is a regulatory objective – that the regulatory capital rules need to allow for business cycle effects over time. It seems increasingly likely that the Financial Services Authority will address this matter.

In the financial crisis, ICAS has publicly stated its view that departure from fair value principles would not be in the public interest and would only weaken investor confidence and increase uncertainty. Suspending fair value accounting would reduce comparability and would be seen as enabling banks and other financial institutions to hide their losses for a protracted period. The example of the Japanese “lost decade” of the 1990s has shown conclusively that the absence of fair values can prolong a crisis. To put it another way, it is far better to get the bad news out in the open immediately rather than deal with it over a protracted period. Fair value accounting may be painful for some institutions – but it is true and fair and will help us move forward.

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Hugh Shields

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