by Martin Jones, ECOVIS Wingrave Yeats, London

It wasn’t long ago that the debate about fair value accounting was confined to accountants.  Then it started creeping into the Board Room and more recently has even found its way on to the political agenda, with some commentators suggesting that it was a contributory factor to the credit crunch and subsequent downturn!

So what is all the fuss about fair value accounting?  It’s probably best to start by explaining what fair value accounting means. Fair value accounting is in contrast to historic cost accounting in that certain assets and liabilities on the balance sheet are stated at “fair value” rather than historic cost.  That all sounds fine – would anyone really want to have “unfair” values on the balance sheet?

The key issue though is what represents fair value?  The fair value of an asset is the amount it would realise in an arm’s length transaction between a willing buyer and a willing seller.  Again, this is fine if the said asset is about to be sold and the sale price has been determined, and also acceptable if there is a ready market for the asset – we all know the current value of investments in FTSE 100 companies, as the price of these are quoted on a daily basis.  Similarly, we can get a good idea of the value of a freehold property on the balance sheet by commissioning a surveyor to carry out an independent valuation. Problems arise when there is no readily available market for the asset and the fair value is determined based on a financial model set up by management predicting discounted cash flows, with all the inherent uncertainties around the assumptions driving the inputs to the model, and hence the valuation.

Could management be tempted to tweak the assumptions to achieve a more favourable valuation?  And how are the auditors expected to get comfortable with the valuation in the absence of any specific guidance?  This causes significant practical problems.  For example, under historic cost accounting, the investment in an unquoted company is recorded at cost and held at that amount until sold (creating a profit or loss on disposal) unless there is evidence of impairment in the meantime, in which case it gets written down to its recoverable amount.  Under fair value accounting, the investment in the unquoted company is required to be “fair valued” or “marked to market” at each reporting period with the resulting surplus or deficit brought on to the balance sheet. As we know, the valuation of an unquoted company is subjective and can result in a wide range of possible values – speak to the buyer and seller involved in any transaction for the sale of a private company to find this out.

What about fair valuing liabilities on the balance sheet?  Surely a liability is just an estimate of the future amount to be paid to settle a debt? Yes, but under fair value accounting, this could depend on all sorts of factors, a lot of which are outside of our control – time value of money, interest rates and foreign exchange rates, which all need to be factored into the equation.  Take pension liabilities as a classic example, with a whole raft of actuarial assumptions to be made in order to determine a figure for pension liabilities to slot into the accounts.
 
But, if it’s just a question of practical difficulties and the inherent weaknesses of financial modelling, surely these can be overcome through the introduction of suitable accounting standards which everyone signs up to? Ah, yes, but didn’t we have these in the US at the time of the collapse of Enron?

An additional complication is our own human behaviour – the herd mentality during the boom times and dare we say it, the risk of catastrophizing during a downturn. As a result, during the boom times, preparers of accounts can become gung-ho with asset values and mark up them up on the balance sheet above the long-term trend value.  Conversely, during the downturn, pessimism sets in, and assets are written down to a distressed sale value, below the long-term trend value, e.g. toxic assets.  This exacerbates the inherent volatilities of fair value accounting and explains why some commentators have suggested that it has not helped during the downturn, as forced write down of assets has increased the capital requirements of banks and restrained lending generally.  So are the accountants to blame?  Surely it’s a case of don’t shoot the messenger?  Fair value accounting just tells us how it is and is prey to the movements of the financial markets, so we have to live with taking the rough with the smooth under this regime.

The principal financial reporting problem under fair value accounting is that certain fair value changes on assets/liabilities e.g. on derivatives, get taken to the profit and loss account and hence impact earnings, making these more volatile.  This is unwelcome for management and reflects poorly on their stewardship function when fair value losses are flying around – the movements of the markets are beyond their control, so why should their results suffer as a result?  However, who was complaining when fair value gains were being added to operational earnings in the boom times?

So where do we go from here?  The US Financial Accounting Standards Board is going to allow banks and other companies more freedom in how they value financial assets.  International Financial Reporting Standards are expected to follow suit and ease fair value accounting rules.

However, until we come up with an accounting framework which is superior to the current mix of historic and fair value accounting, then I guess we are just going to have to muddle through with the current framework.  Reverting to a full historic cost system would be a retrograde step, and does anyone really want a full fair valued balance sheet?