Mark to Make Believe

(Conclusion)

The US SEC in its clarification of FAS 157, stated that “ ‘disorderly transactions’ are not determinative sources in measuring fair value. The use of market quotes as fair value assumes an ‘orderly transaction’ among market participants. An orderly transaction involves market participants that are willing to transact and allows for adequate exposure to the market. Thus, distressed, forced or fire sales are not considered as ‘orderly transactions’ and should not be the sole source of fair value information.” As for IFRS, AG 69 of IAS 39 maintained that “underlying the definition of fair value is the presumption that an entity is a going concern without any intention or need to liquidate...fair value is not, therefore, the amount that an entity would receive or pay in a forced transaction, involuntary liquidation or distressed sale.”

Affected entities, particularly banks, did not waste time in assessing whether current market conditions particularly for MBS and other credit-linked instruments qualify as a disorderly market or whether the prices being quoted indicate a fire sale. Various financial models were developed to determine prices for MTM purposes with the intention of churning prices that better “reflect economic reality.” Adding to the subjectivity, inputs sourced from observable market sources were likewise adjusted to arrive at the “true value” of a particular asset.

What’s daunting about the subjectivity is not only the accuracy of the estimate, who’s wrong or right or how misleading the financials have become, but the comparability among similar entities and how difficult investment decisions have become as a result thereof.

To shoot or not to shoot the messenger

Perhaps, the best empirical evidence that junking fair value accounting has very little to do with economic recovery is what happened to Japan for much of the ‘90s. Japanese companies, particularly banks, closed their doors very early against fair value accounting and other accounting improvements being introduced by the International Accounting Standards Council at that time, with the hope of preserving capital and earnings. However, with very little fair value information available, investors, both local and foreign, were oblivious as to “how much things are really worth” and parked their funds elsewhere. The resulting capital flight and liquidity crunch apparently prolonged the economic recession which, unfortunately, continues up to this very day. In the US, if fair value accounting were scrapped and historical cost accounting were put back to prominence, the investment analysts and the big-time investors like Warren Buffett would adjust for it anyway, because, regardless of the accounting method used, their concern would only be “how much things are really worth.” If you think fair value accounting is bad enough, consider the alternative.

What many detractors of fair value accounting tend to forget is that the root of the global financial crisis is economic rather than accounting in nature. Undeniably, credit screening and evaluation standards during the boom years in the United States were very loose and substandard. Securities that relied on the quality of these receivables were issued and traded globally. These securities attracted various entities because of their superior yield (which turned out to be mispriced considering the real risk of these investments) and the perception that these instruments are very safe (since the underlying receivables originated in the US and were “well diversified”). The investors’ appetite for these securities just kept growing. Living beyond their means, their purchases were funded by taking in too much leverage — borrowing short-term and selling put options. Combining dodgy and relatively non-saleable assets with high leverage comprising mostly of short-term liabilities is a sure recipe for disaster for any entity, regardless of the accounting method. With all of these Trojan horses in place, the entire structure inevitably fell apart like a house of cards when you take away the base and leaves a carnage no one has ever seen since the 1930s — well, that’s bad news but is it the fault of the one who tells us there’s something wrong with the whole financial system? None, in my view, answers this better than JPMorgan Chase & Co. analyst Dane Mott who said, “Blaming fair value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick.”

On the other hand, fair value accounting, as it is right now, is far from being ideal. What needs to be addressed immediately is the creation of more concrete and comprehensive guidelines in determining fair value, particularly for assets with prices quoted in distressed or inactive markets, for purposes of sound and proactive financial reporting. I am not suggesting that quoted prices for assets traded in distressed markets should be totally ignored for valuation purposes. Somehow, the deterioration in the value of these assets has to be factored into their valuation. As once pointed out by the US SEC, in determining fair value for distressed or inactive markets, “multiple inputs from different sources may provide the best evidence of fair value.”

These multiple inputs should then be consolidated using an acceptable financial model. The choice of financial model to use should be determined through these guidelines, which must transcend several layers of walls and boundaries. These guidelines should have applicability and acceptance not only across industries and geographical lines but also across the different sets of accounting standards (whether IFRS or US GAAP). The latter is a heavier burden for the effective rollout of these guidelines because it would require harmonization and convergence among the different GAAPs. Another area of improvement is with respect to enforcing strict compliance with disclosure requirements for financial models used for asset valuation and the related assumptions. While there is a need to improve and harmonize existing disclosure requirements, there is already, I believe, an abundance thereof, whether under IFRS or US GAAP, that would provide sufficient information to investors. What is lacking is strict implementation and the unwavering imposition of stiff penalties and sanctions for non-compliance.

(Paul Bernard D. Causon is a Partner for Audit Services of Manabat Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. This article is for general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email [email protected] or [email protected]).