What is Fair?
The International Accounting Standards Board (IASB) has just released a new guide to fair value accounting in inactive markets. This is a reaction to the criticism that has blamed the banking crisis on fair value accounting.
The banks have had to write off billions in unrealised losses due to the mark-to market of their investments in collateralised debt obligations (CDOs) backed by sub-prime mortgages and other loans. The papers have become illiquid as the losses on the underlying loans are mounting thus making investors reluctant to buy the papers off the banks when the underlying risks are not transparent.
The losses on the CDOs have depleted banks’ capital base and stopped them from lending new money to their customers. Many have therefore called for a halt or at least a suspension of the usage of fair value, especially for financial institutions.
However, it is not the fair value rulings that have caused the problem but rather the reckless lending practices of the banks. Fair value sends a message to the market, indicating the state of the banks - and that should not be ignored. So suspending fair value treatment is like shooting the messenger and ignoring the message.
Had the banks been allowed to keep the papers on the books at the historic values their capital base may have looked sound, but the underlying health of the business would not have been any better. It would just have given the banks more time to get into even more trouble by going on as if nothing had happened, making the eventual crisis even more severe.
The critics have pointed out that if fair value only relies on the prices in a market which is dominated by fire sales from distressed investors it will drive prices down to unrealistic levels. This new guide deals exactly with that scenario and will help the banks to apply realistic values to their investments.
The fair value accounting principle has long been blamed for many ills and ways have been found to reduce the negative sides of the rule, not least hedge accounting.
Any treasurer involved in hedging transactions can sing a song about this, but the fair value principle is still the best solution to tell the market about the current health of the company. Without the application of fair value investors and creditors would be left guessing about the underlying financial health of the organisation. More information is still better than less information.
For example, leaving derivatives on the books of corporates at their acquisition price would just hide potential losses. We would instead see scandals where companies have lost large sums on derivatives but hidden it from investors until it’s too late to rectify the problem. And then we would hear cries to instate fair value accounting instead.
It is better to keep to the principle and then deal with any unwanted side effects using other methods such as hedge accounting. The IASB’s guide on Measuring and disclosing the fair value of financial instruments in markets that are no longer active can be found here.
