EDHEC-Risk Concept Industry Analysis Featured Analysis Latest EDHEC-Risk Surveys Features Interviews Indexes and Benchmarking FTSE EDHEC-Risk Efficient Index Series FTSE EDHEC-Risk ERAFP SRI Index EDHEC-Risk Alternative Indexes EDHEC IEIF Quarterly Commercial Property Index (France) Hedge Fund Index Research Equity Index Research Amundi "ETF, Indexing and Smart Beta Investment Strategies" Research Chair Rothschild & Cie "Active Allocation to Smart Factor Indices" Research Chair Index Regulation and Transparency ERI Scientific Beta Performance and Risk Reporting Hedge Fund Performance Performance Measurement for Traditional Investment CACEIS "New Frontiers in Risk Assessment and Performance Reporting" Research Chair Asset Allocation and Alternative Diversification Real Assets Meridiam Infrastructure/Campbell Lutyens "Infrastructure Equity Investment Management and Benchmarking" Research Chair Natixis "Investment and Governance Characteristics of Infrastructure Debt Instruments" Research Chair Société Générale Prime Services (Newedge) "Advanced Modelling for Alternative Investments" Research Chair CME Group "Exploring the Commodity Futures Risk Premium: Implications for Asset Allocation and Regulation" Strategic Research Project Asset Allocation and Derivative Instruments Volatility Research Eurex "The Benefits of Volatility Derivatives in Equity Portfolio Management" Strategic Research Project SGCIB "Structured Investment Strategies" Research ALM and Asset Allocation Solutions ALM and Private Wealth Management AXA Investment Managers "Regulation and Institutional Investment" Research Chair BNP Paribas Investment Partners "ALM and Institutional Investment Management" Research Chair Deutsche Bank "Asset-Liability Management Techniques for Sovereign Wealth Fund Management" Research Chair Lyxor "Risk Allocation Solutions" Research Chair Merrill Lynch Wealth Management "Risk Allocation Framework for Goal-Driven Investing Strategies" Research Chair Ontario Teachers' Pension Plan "Advanced Investment Solutions for Liability Hedging for Inflation Risk" Research Chair Non-Financial Risks, Regulation and Innovations Risk and Regulation in the European Fund Management Industry Index Regulation and Transparency Best Execution: MiFID and TCA Mitigating Hedge Funds Operational Risks FBF "Innovations and Regulations in Investment Banking" Research Chair EDHEC-Risk Publications All EDHEC-Risk Publications EDHEC-Risk Position Papers IPE EDHEC-Risk Institute Research Insights AsianInvestor EDHEC-Risk Institute Research Insights P&I EDHEC-Risk Institute Research for Institutional Money Management Books EDHEC-Risk Newsletter Events Events organised by EDHEC-Risk Institute EDHEC-Risk Smart Beta Day Amsterdam 2017, Amsterdam, 21 November, 2017 EDHEC-Risk Smart Beta Day North America 2017, New York, 6 December, 2017 Events involving EDHEC-Risk Institute's participation EDHEC-Risk Institute Presentation Research Programmes Research Chairs and Strategic and Private Research Projects Partnership International Advisory Board Team EDHEC-Risk News EDHEC-Risk Newsletter EDHEC-Risk Press Releases EDHEC-Risk in the Press Careers EDHEC Risk Institute-Asia EDHEC Business School EDHEC-Risk Executive Education EDHEC-Risk Advances in Asset Allocation Blended Learning Programme 2017-2018 Yale School of Management - EDHEC-Risk Institute Certificate in Risk and Investment Management Yale SOM-EDHEC-Risk Harvesting Risk Premia in Alternative Asset Classes and Investment Strategies Seminar, New Haven, 5-7 February, 2018 Investment Management Seminars Contact EDHEC-Risk Executive Education Contact Us ERI Scientific Beta EDHEC PhD in Finance
Features
Fair Value Accounting - November 25, 2008

The Fair Value Controversy: Ignoring the Real Issue

In the context of the measures being taken to put an end to the current financial crisis, the extent to which fair value accounting can be blamed—or whether it can be blamed at all—for the intensification of the slump has been widely debated.

This new EDHEC position paper shows that this debate, which ignores the real issues, has led to accounting changes that are at odds with their objectives. We examine the relevance of the accusations levelled at fair value and of the responses proposed in an attempt to improve the use of fair value accounting and make it more relevant to the economic realities faced by banks as well as by companies in general.

The critics of fair value accounting have failed to consider the problem upstream; that is, they do not first examine the role of accounting. As it happens, the objective of accounting is to provide as reliable a description as possible of the net assets of a company at a given time, in the environment prevailing at the moment of the statement of the accounts. The role of financial reporting is to act as a source of information; it does not have a prudential role. Although accounting doctrine has taken a more financial approach in recent years, accounting cannot replace financial and prudential analysis.

In an attempt to reduce the pro-cyclicality of accounting, some have advocated suspending fair value accounting or even doing away with it altogether. The October 2008 amendments to IFRS 7 and IAS 39 go in this direction, as they now make it possible, on certain conditions, to report at historical cost transactions that had previously been reported at fair value.

In our view, this change is likely to hide the real risks to which companies are exposed and to increase the mistrust of the financial community, which will continue seeking information in fair value terms, as it did during the previous financial crisis early in the current millennium.

In 2002, as it happens, when accounting was done at historical cost in most European countries, the pro-cyclical nature of accounting rules had already been made clear: at the time, insurers had reported massive provisions for durable depreciation, forcing them to cede a great portion of their stock portfolios and to raise capital to maintain their solvency margins.

As early as 2006 our research showed the limits and the impact of certain accounting treatments adopted by the IASB. All the same, the accusations currently being levelled at fair value seem altogether distorted to us and as such cannot serve as a foundation for reflection on ways of resolving the crisis. That the measure of fair value and the accounting treatments adopted by the IASB are highly debatable doesn’t necessarily mean that fair value accounting itself must be rejected. In our view, a return to accounting at historical cost would be mistaken; it would only prolong the crisis, much as it prolonged the Japanese banking and financial crisis.

Even though fair value accounting reveals a weakening of bank balance sheets, it is not the domain of accounting to estimate the need for additional capital and/or for a necessary curtailing of business. That is the role of the regulator. Accounting is but one of the available media, and the judgment of the regulators should also be founded on the ability of financial institutions to recover in the near future, on their real susceptibility to the crisis, and, more broadly, on their ability to manage the situation and turn it around. This prospective dimension is not the province of accounting.