Fair Value Accounting and Improving the Transparency of Financial Instruments

The International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) share a vision of a single set of high-quality global accounting standards and are working on a joint project on financial statement presentation and a movement towards fair-value accounting. Following an earlier article in the Financial Times (FTfm supplement), Mr. Raghu Mandagolathur, president of CFA Kuwait, and Mr. Stephen M. Horan, head of private wealth and investor education at CFA Institute, discuss the role of fair value accounting in the current market environment.

While valuation is a global theme, it is has secured a great deal of recent interest in the GCC region given the stress companies in the region have faced over the last two years. The region’s stock markets still suffer from high volatility and speculation primarily due to stakeholder’s inability to assess the impact of changing asset values. Fair value accounting would enable regional companies to reduce overall borrowing cost as lenders/investors will be in a better position to assess the risks better. However, it won’t solve everything especially challenges related to valuing illiquid assets. GCC companies and lenders would still have to deal with the issue of “hard to value” assets. Central banks in the region have been proactive in some cases in enforcing fair value requirements. However, regulatory coordination among various GCC central banks on this extremely important aspect will be highly welcome.

Q: What are the benefits of fair value accounting?

Fair value accounting is intended to reflect in reported financial statements the essential economic, market-based information related to a firm’s activities. It can provide early warnings of changes in a firm’s financial position by continuously reflecting the changing value of its assets and liabilities, and thereby provide a more accurate picture of firm risk than historical cost accounting, which can obscure and defer recognition of economic realities.

Q: Why switch from historical cost accounting?

A historical cost regime can provide managers an option to realize gains when asset values increase but to conceal losses when asset values drop. This flexibility can encourage managers to undertake speculative projects knowing that historical cost puts a floor on their reported losses. Although recording impaired assets at the lesser of their original cost or their current market value as dictated by traditional rules mitigates this incentive, adherence to this rule depends on management judgment.

Moreover, managers may have an incentive to pursue excess leverage or hidden risks because historical cost accounting artificially smoothes results. Ironically, the incentive to take on more risk than is justified by the economics can result in turmoil like we are currently experiencing in credit markets.

Q: Why do stakeholders prefer one over the other?

Corporate managers tend to prefer historical cost accounting, believing that the fundamental role of accounting is to provide a verifiable record of historical transactions. It tends to stabilize reported earnings over time, which may also smooth out a manager’s incentive-based compensation. Corporate managers believe that historical cost reduces market volatility and that fair value information is costly to obtain.

Investors, on the other hand, tend to value accounting information that reflects underlying economic conditions. According to a recent survey of CFA Institute members, 79% of respondents believe that fair value accounting improves transparency of financial institutions while 74% believe that it improves market integrity.

Q: Are investors asking managers to value their companies for them?

No. Security valuation hinges on the quality of information managers convey. Fair value information on assets and liabilities simply provides investors a better starting point and complements rather than replaces the external valuation process.

Q: Did fair value accounting cause the meltdown in credit markets?

Some argue that fair value write-downs triggered margin calls and capital requirement violations that forced liquidations that suppressed prices further and caused further write-downs. However, fair value accounting probably brought the extent of write-downs from sub-prime financial market instruments to light sooner, which may have prompted more timely intervention from central banks and in turn prevented further deterioration of market liquidity. Lower-of-cost-or-market practices would have required write-downs in any case.

Q: What are some of the challenges of fair value accounting?

Ideally, direct market quotes of actively traded assets can be used to mark-to-market. The credit crisis highlights that market prices of some financial instruments may not be readily observable, especially in illiquid or unbalanced markets. For these assets, fair value might be estimated using prices of similar securities in active markets.

Where this approach is not feasible, a specific valuation technique that relies on external inputs as much as possible rather than internally generated inputs is necessary. While this approach may seem onerous, financial institutions should presumably have valuation expertise for instruments in which they transact. The lack of such expertise should not be construed as a deficiency in the accounting regime. Fair value accounting during the credit crisis helped reveal poor risk management and valuation infrastructures.

Q: What problems arise if some assets and liabilities are not reported at fair value?

A mixed attribute accounting model, which blends fair value and historical cost treatments, can create mismatches with unintended consequences. For example, if a firm uses fair value accounting for a derivative security intended to hedge the interest rate risk of a loan recorded at historical cost, the accounting mismatch can create artificial volatility in the reported value of the combined position.

Markets, however, have an uncanny ability to discern economic reality when given the proper data. For example, markets place higher price multiples on earnings it judges to be more persistent. Studies also show that market prices tend to respond negatively to changes in accounting principles intended to artificially inflate earnings.

Q: Can fair value accounting be improved?

Financial statement presentation proposals under consideration by the IASB and FASB can help isolate the impact of fair value reporting on reported financial performance. These proposals suggest separating gains and losses from financial instruments from operating activities. This will improve understandability in either full fair value or mixed attribute measurement regimes.

Q: What is your advice for fund mangers?

Most importantly, fund managers should become familiar with using the additional information available through fair value reporting and distinguish mixed attribute volatility from true economic volatility. Second, those who appreciate the added value and transparency of fair value accounting might demand fuller disclosure, such as specifics about valuation methodology, its inputs, and its sensitivity to those inputs. Finally, fund managers might consider supporting the IASB and FASB efforts to promote fair value accounting and to improve financial statement presentation.

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