A year ago “fair value” was largely an accounting concept, hotly debated by those with an interest but considered quite academic by the wider business world. Yet since the credit crunch began and markets seized up, the concept’s merits and drawbacks have put accounting at the heart of heated arguments over valuations and writedowns.
A number of banks and insurers have publicly and privately lobbied regulators to relax the rules, complaining that the strict system has overstated their likely losses and has risked pushing the entire financial system into chaos by introducing a spiralling series of ever-decreasing values.
Among the notable critics, Henri de Castries, chief executive of Axa, the French insurer, labelled accounting the thermometer of business and questioned whether fair value was the right measurement system. AIG, a US rival, took up the baton – Martin Sullivan, former chief executive, warned of the potential for unintended consequences of using the the accounting method in what he called uncharted waters for the financial system.
Yet on the other side, Goldman Sachs, the investment bank with one of the best performances through the credit crunch, took aim at industry proposals to loosen the valuation rules by calling the plans “Alice in Wonderland” accounting.
How contentious can it be? Put simply, fair value is “marking to market”, or the practice of marking assets and liabilities at their current market value on the balance sheet. The concept is not new – banks, which run trading books, have been doing this for decades. Internally, they mark their books daily.
The aim is simple: to produce independently verifiable values, where possible without relying on management views for the numbers.
But many financial instruments have faced tough going in the thinly traded markets of the credit crunch. This has made the value of some exotic structured products virtually impossible to verify with any certainty.
The assets’ owners have been hardest hit by the fact that accounting rules require many of the losses and gains, including those on derivatives such as structured credit products, to flow through the income statement. This means the market falls of the past year have produced a direct hit to the bottom line – even though the securities have not been sold. Banks such as Merrill Lynch and UBS have written down their holdings by more than $40bn each and the total bill for writedowns in the industry is now more than $400bn.
This has produced a chorus of complaint from some of the biggest players in the business including AIG, which reported $11bn in writedowns in the first quarter of this year – and more since – but reckoned that, of that $11bn, only $900m would end up actually lost because it could hold the instruments until they matured. It argued, therefore, that it should not have to take a $11bn-sized hit for something that was likely to result in less than a tenth of that.
But those who apply the rules, from regulators to auditors, have held firm.
“Standard-setters and auditors shouldn’t be told they’ve got it wrong just because there’s a difficult market right now,” says Richard Bennison, UK head of audit at KPMG. “Are the rules perfect? Probably not, but they’re certainly a move in the right direction.”
Richard Sexton, head of assurance at PwC in the UK, says the writedowns, and their prominent position in the accounts, have forced the financial industry to deal with its problems far more quickly.
“Accounting doesn’t create reality, it reflects it. Here it has clarified where there are some issues and has illuminated them,” he says. “In the criticism, there is an element of ‘we don’t like the answer’.
“If you use market valuations, that by nature creates volatility because markets are volatile. But accounting is only reflecting that volatility.”
The extreme moves in markets have produced valuations so low that they have alarmed many. but Anthony Clifford, a partner at Ernst & Young in London, says: “For those that complain these values were not reasonable, they should note that the basis for many hedge fund collapses was margin calls based on these very same market prices.
“There is this argument that it is better for the world to delude ourselves by not marking to market. But a number of organisations have had to sell these assets and realise losses at these low prices.”
In July, for example, Merrill Lynch caused a stir when it sold collateralised debt obligations and realised $6.7bn, or just 22 cents in the dollar. The low prices could serve as a reference point for other banks’ valuations.
Now accountants’ focus is moving on to what the profession can learn from the last year and whether the standards can be improved.
The International Accounting Standards Board, for example, is undertaking a series of projects including consulting on whether it can simplify the rules on financial instruments. It has another expert group meeting to discuss issues around producing valuations in illiquid markets.
“There is a real debate as to whether we should calibrate prices from credit indices if there are no market prices. Some of these indices are very thinly traded and can be manipulated and they are only one indicator among many,” says Mr Clifford.
The scale of the shock to both corporate executives and investors does suggest that companies did not fully understood the implications of fair value for their accounts and that both investors and executives were unaware of some of risks lurking in many complex credit products.
Mr Sexton says it is a “reasonable question to ask whether people who are using the information have understood what it is telling them. It’s perfectly right that preparers and others should reflect on whether it could be presented more clearly.”
Mr Bennison believes part of the pain has come in educating investors and executives about the risks.
“Was there sufficient disclosure about some of the risks around market volatility? You could say there should have been more disclosure. It’s partly education and a misunderstanding of the size and exposure of some of the banks,” he says.
He defends the practice of fair value in this case: “You have to go back to the objective and purpose of accounts. It is not to determine what the future might hold and what future values might be. It is, at a point in time, to try and give a picture of the value at that point. It isn’t an indication of the market worth of that business and it isn’t to even out the good and bad times.”
And Mr Bennison stresses: “It is up to investors to make their own assessment of what they believe might happen in the future.”