Fair value accounting rarely fair

“What accounting throws up is extremely relevant to business decisions, so we have to make decisions that minimize volatility,” explained Bob Brooks, vice-chairman of Scotiabank. “Fair value accounting, as is currently applied, has produced far more harm than good — for all participants, except for accountants [due to] the income statement volatility [it produces].”

Brooks’s arguments were supported by other industry representatives, including Donald Chu, CFA, director, financial institutions ratings, S&P Toronto; Diane Hinton, director, financial institution ratings, S&P New York; Karen Stothers, managing director, accounting policy division, OSFI; and Robert Wessel, CA, CFA and managing director, propriety equity, National Bank Financial — all end users of FVA financial statements.

“As an accountant and as a regulator, I know the banking business,” said Stothers. “And the standard setters within this industry are trying to make [the accounting] simple, because they are trying to sell a message. The problem is that fair value accounting is extremely complicated and the market it exists in is extremely complicated. [The reality] is that we are not dealing with just accounting, we are talking about economics for everyone.”

Brooks added that,while FVA attempts to value investment vehicles by interpreting today’s market value, proponents of this accounting standard fail to appreciate how the market works.

“Fair value accounting will show a TSX sticker price for 3,000 shares the same as 300,000 shares — but the market shows us differently,” explains Brooks.

He believes that the problem is in the approach. “We tend to opt for disclosure as a way to mitigate underlying problems — and it sounds good — but [fair value accounting and other industry initiatives] are just Band-Aid solutions.”

For advisors and their clients, this debate has a far-reaching impact. Chu sums up the impact by saying, “there is no consistency in the marketplace.” This lack of consistency — and the need to rebuild financial statements — creates uncertainty and diminishes a professional’s ability to valuate a company. “It means [we’ll] never be able to assess a business properly.”

Evaluating properly, however, was the main intent of FVA.

Philip Arthur, senior partner at Ernst & Young, cited a recent article in The Economist that defended FVA and explained that the “4,000 pieces that make up a Porsche are a lot more difficult to value than the Porsche itself.” It’s this inability to measure value that creates volatility, not the method of accounting. Yet, despite difficulties, he and other accountants “do want to try,” to assess and valuate businesses properly.

As a fan of FVA, Arthur has worked with banks and life insurance companies that have “over the last 15 years, been using a fair value accounting-like system.” As such, Arthur and colleague Gord Cetkovski, partner at PricewaterhouseCoopers LLP, believe that out of the three accounting alternatives — amortized costs, fair value and a mixed attribute of the first two — fair value is the best option.

“Cost is a static measurement,” explained Arthur. “Fair value is more dynamic and it forces better development of terms, economics, risks and values.”

While critical of FVA, Stothers is also not convinced that this accounting standard needs to be replaced; however she does question whether FVA is providing the better disclosure it intended.

“[Financial statements] should provide more clarity in how models are working and provide a better understanding of the business. I haven’t heard if fair value accounting is the way to get that.”

These and other questions come on the heels of a report released by the Basel Committee on Banking Supervision. This report, released June 12, concluded that the evaporation of liquidity made primary and secondary transaction prices unavailable for many complex structured products. This prompted some banks to respond by switching from valuation methods based on observable prices to methods that relied more on modeled valuation.

“During the turmoil, banks had difficulties in selecting appropriate valuation inputs,” the report explained. “In particular, it was necessary to assess whether observable inputs were reliable and did not represent distressed sales.”

This dilemma, in fact, epitomizes the difficulty many industry professionals have with fair value accounting.

Prior to and during the crisis, banks assumed that market-quoted prices could be relied upon to ascertain fair value. Yet, these quotes failed to hold up under subsequent stressful conditions, with “many products that proved difficult to value during the market turmoil,” explained the report. The authors continued by saying that “the over-reliance by many banks and other market participants on a single information source to determine value was a fundamental weakness in risk management.”

While credit rating agencies have received the brunt of this criticism, many financial service professionals, including Brooks, believe accountants are just as responsible.

“There is no question, and this has really been shown in the last 12 months, that accounting drives business decisions,” explained Brooks.

“The problem with incorporating assumptions about the future into accounting records is that you are bringing today’s present value into financial statements and those definitions and values are wrong and will change. Inherently. this is a process that will create a lot of volatility.”

Neri Bukspan, managing director, credit market services, S&P, summed up the debate by saying, “the challenges associated with fair value can only be overcome by recognizing that it is impossible to translate the complexity of an economic event into a single number — whether presented using historical or amortized cost, fair value or any other agreed-upon measurement basis — and consequently, providing additional instructive disclosures and greater transparency around fair value measures is essential.”

Filed by Romana King, Advisor.ca, romana.king@advisor.rogers.com

(06/13/08)