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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.


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http://www.edhec-risk.com/features/RISKArticle.2008-11-25.0644

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