Fair Value

Viewpoints

Viewpoint: Fair-Value Accounting’s ‘Truth’ Is Dubious

By Alex J. Pollock

1160 words

25 April 2008

American Banker

10

Vol. 173, No. 80

English

(c) 2008 American Banker and SourceMedia, Inc. All rights reserved.

WASHINGTON — “Fair-value” accounting is obviously appropriate for you if you are a securities broker. But should everybody else in the world be accounted for as if they were securities brokers? That is hardly obvious; indeed, highly dubious.

From the proponents of this dubious proposition we constantly hear that they are only insisting on “the facts” of market prices. Of course, they admit that in many cases there is no active market, or no market at all, but then we need estimates – as is true in many other areas of accounting. They also admit that markets can be panicked and reach fire-sale prices that will be judged by later observers as irrational, but they say that, nonetheless, this is “the fact” of the market price now.

For example, Todd Davenport’s useful summary of the fair-value debates [“Fair Value: Few Fans, But Fewer Alternatives,” March 24, p. 1] quotes these representative sentiments of fair value supporters:

“A lot of prices are probably not what most people would feel are fair and appropriate in normal circumstances. But that’s still what the market price is.”

“Let’s not hide from the truth.”

But what is accounting truth? It is never, and never can be, simply the facts. It is facts treated according to some theory to calculate what the theory defines as its results, for example, the defined concepts of “profit” and “capital.”

In other words, there is no such thing as accounting truth arrived at in any simple way – there are only facts (and estimates, projections, and guesses) turned into accounting results as defined by some theory.

So one can easily grant that today’s illiquid, panicked price is a fact but disagree with the theory of how this fact relates to the financial statement.

Accounting theories are like those of politics and philosophy: They are debated for years without a clear demonstration of being correct – they are like neither mathematical nor logical proofs, nor like the results of scientific experiments. This makes them intellectually intriguing (at least to some of us) and apt to inspire ardent advocacy and opposition, as well as leaving them subject to volatile fashion. For example, the Securities and Exchange Commission absolutely demanded historical cost accounting for several decades (assuming you were not a securities broker), but now the fashionable theory is fair-value accounting. How good a theory is it?

Theories may be judged (or at least argued over) on conceptual and public policy grounds. Opponents of fair value point out its many practical difficulties, such as the uncertainty of what a fair price may be when there are no trades and no real bids. But given the prevalence of estimates in accounting, this is not in principle an objection that impresses the fair-value proponents.

The important objections have to be in principle, those that clarify the conceptual and policy failings of the fair-value theory. Here are three:

* The fair-value theory inappropriately treats operating businesses, whose business is to generate net cash flows over time, as if they were securities brokers, whose business is the daily buying and selling of securities. My colleague Vince Reinhart has aptly called this the “banking view,” as opposed to the “securities view.” The banking view is quite articulately set out in detail in a recent white paper from the International Banking Federation, “Accounting for Financial Instruments Conceptual Paper.” It defines a clear, practical alternative theory.

* Fair-value accounting means that deterioration in the quality of a company’s own debt, which reduces the debt’s market price, is reported to the public as an increase in the company’s profit and capital.

Correspondingly, improvement in the company’s credit quality, resulting in its debt being more valuable, creates an accounting loss and reduction in capital. A Barron’s article recently called this “a mere accounting illusion.” It is worse than that: It is an absurdity. When an absurdity naturally follows from a theory, we have to wonder about the theory.

* Fair-value accounting has particularly perverse results when applied in the midst of a market panic, when markets are neither liquid, active, nor orderly.

What is the meaning of a “market price” when there is no market? Then prices must be estimated by projecting cash flows and applying a discount rate. Yes, but which discount rate? Fair-value accounting forces the huge uncertainty premium or panic discount rate of distressed markets into the profit and capital calculations of entities whose contracted-for cash flows may all be realized. It is not in the least clear that this makes any sense.

Consider this recent definition of “solvent” from St. Louis Federal Reserve President William Poole:

“A firm’s assets valued at normal levels of economic activity cover the firm’s liabilities, leaving a reasonable level of net worth. The firm’s capital can absorb losses occasioned by normal business risks … in my view, economic depression, hyperinflation, and financial implosion are not included.”

Fair-value proponents like to argue that “historical cost is irrelevant.” But this is not really the issue. Fixed-income assets have a principal to be repaid and interest payments in between.

If all interest and principal is going to be paid as agreed, what is the right accounting representation?

Consider a five-year bond financed with a five-year certificate of deposit to yield a spread of 2% and a net cash flow of 2% a year. Should the accounting reflect that steady cash flow, as long as the credit is good? “Of course,” says the banking view. “Of course not,” say the fair-value theorists, “we have to move around the reported profits and capital every quarter to imbed the different discount rates the market, or lack of market, is implying.”

From a public policy point of view, fair-value accounting is distinctly pro-cyclical, building market excesses of both optimism and pessimism into reported profits and capital. In the midst of a major bust, where we are now, this reinforces the downward cycle of panic.

Moreover, when fair-value accounting is dependent upon the prices of derivatives, when the cash market is not trading, it exposes the financial system to manipulation.

By purposefully driving down the price of the derivative to drive up reported losses, speculators can profit from short positions elsewhere.

Accountants may take the view, “I must follow my accounting theory, though the heavens fall,” but thoughtful government policymakers are unlikely to share the view that the fair-value accounting theory is society’s highest priority – especially since it is a pretty dubious theory.

Mr. Pollock is a resident fellow at the American Enterprise Institute. He was previously the president and chief executive officer of the Federal Home Loan Bank of Chicago.

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