Where Is Fair Value Accounting Headed?

Before the financial crisis, fair value accounting was in vogue. When the crash happened, politicians, policy analysts and pundits lined up fair value accounting against the wall, together with regulators asleep at the watch, excessive use of leverage, and so on. Fair value accounting – defined in simple terms as the booking of numbers based on current market value – was named a catalyst in exacerbating the crisis.

 
The International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) thus came together in late 2008 to reconsider all aspects of accounting for financial instruments, and to develop a common guide to fair value measurement.
 
To “fair” or not to “fair” – this, according to Stephen H. Penman, is now “the big debate in accounting”. Penman, who is George O. May Professor and the Morgan Stanley Research Scholar at Columbia University's Graduate School of Business, was delivering a lecture at SMU's School of Accountancy as the Cheng Tsang Man Professor, where he attempted answers to the question: Is fair value accounting fair accounting for shareholder value?
 
Singapore should pay attention to this debate, given its bid to become the regional financial centre and the Singapore Accounting Standards Council’s commitment to fully adopt the International Financial Reporting Standards developed by the IASB by 2012. What the two major accounting standards bodies – IASB and FASB – ultimately decide on will have implications not only on how companies book their accounts in future. It will also affect the external financial environment economies will have to navigate.
 
Where are the winds blowing on the fair value issue? Has the last crisis changed the perception towards fair value accounting? Will fair value accounting continue to gain popularity? After all, fair value, despite the criticisms, gives potential investors the current market value of financial instruments. Penman’s personal take, to laughter from the audience, was: “I think there has to be one more crisis.”
 
Here to Stay
Both FASB and IASB appear to be seeking not so much to remove fair value from balance sheets, but to determine the extent it would advance. In America, the scale seems to be tilting towards more fair value, with the FASB proposing that all financial instruments, including bank loans and deposits, be reported at fair value. On the other hand, the international body, IASB, leans towards a mix of fair value and amortised cost, seeking to retain amortised cost accounting for bank loans, with the option of fair value accounting.
 
The public consultation process on the respective proposals is still ongoing. Nevertheless, Penman worries about the FASB’s proposal, in particular the momentum towards fair-valuing bank loans and core deposits.
 
“This is quite a radical stand,” he said. “We in accounting have always had the discipline to say that you don’t book assets from trading with customers until the customer turns up and actually gives you a claim against them.”
 
To recognise and value intangible assets, the FASB is proposing that “in calculating the present value of the average core deposit liability amount, entities should consider future core deposits.” This, Penman asserts, is not the same as mark-to-market accounting. Rather, it opens the way for the bank to record in the accounts estimates of the deposits it would get in the future.
 
“Think about it,” he said. “If any manager of a business starts booking future sales or starts booking sales when we don’t have a customer, we lock them up. We say, ‘How can you?’”
  
Greasing the Wheel
A professed disciple of the so-called Benjamin Graham doctrine of fundamental investing, Penman refutes the argument of the proponents of fair-value that historical cost accounting is like driving down the street looking at the rear mirror. He argues that historical cost accounting “is quite forward looking” because “if I know the sales now, the margins, I’m going to have a very good predictor of what the future value might be.”
 
Graham (1894-1976) was an American economist and Wall Street analyst whose seminal work, The Intelligent Investor, was once famously described by Warren Buffett as “the best book about investing ever written”. Graham, according to Penman, teaches one to beware of prices. “Price is not value. Price is what you pay, value is what you get. There is a difference,” he said.
 
There must a distinct line between what one knows and what one is speculating. There is nothing fundamentally wrong with speculation. What Graham advocates is not so much avoiding speculation, but making sure the speculation is grounded on known factors. Only then can investors challenge the price. In challenging the price, Graham’s advice is to be very careful not to include price in the calculation, because one then loses the ability to challenge the price.
 
What does this mean for accounting professionals? Instead of trying to guess the current prices of assets and liabilities, accountants should remember that it is not their job to speculate on prices – leave that to the analysts and the investors they serve. Rather, Penman said, accountants should keep prices out of the accounting. To do otherwise is to inject “water in the balance sheet,” which will quickly evaporate under the sun.
 
This is precisely what happened in the recent financial crisis. Loan securitisation, which began some two decades ago, took off in a big way in the years leading up to the bust – but not before originating banks, mortgage brokers and the securities industry, enticed home buyers to take up cheap loans, and then packaging them and hawking them as investment grade products.
 
Under fair value accounting, these securities were marked-to-market, moving the loans away from the information at the originating banks. At the same time, the banks were easy with their lending, and interest rates were kept at historical low to fuel the post 9-11 economy. Due diligence to determine the credit-worthiness of the borrower became so minimal that tax returns were not required and 10 minutes was all it took for loans to be approved, said Penman.
 
A bubble was created and this pushed up the fair value of bank loans. Simply put, banks were lending against bubble prices in their books, increasing leverage and perpetuating the vicious cycle. When the crash came, big chunks of the market turned to vapour and fair-valued asset prices plunged, forcing lenders to take huge write-downs. “Clearly, cheap money was a problem, [and] so were securitisation and leverage,” said Penman, “but fair value accounting was the grease in the wheel.”
 
Risky Vehicles
Fair value accounting flies in the face of conventional accounting wisdom, which demands that accounting should be independent and earnings have to be earned. That is a key issue, Penman noted.
 
Fair value accounting gives earnings as estimates based on management’s expectations. This has the effect of magnifying risks that investors have to bear, opening the door for accounting acrobatics using the likes of Special Purpose Entity (SPE) and Structure Investment Vehicle (SIV) that were kept off the balance sheet. Thanks to the Enron debacle and the subprime mortgage crisis, SPE and SIV have become bywords not for savvy financial engineering but for skeletons in the closet.
 
Furthermore, with fair value accounting, borrowing is no longer against hard assets but against expectations. It encourages dividends and bonuses to be paid out of conjectured profits, which Penman denounced as a “Ponzi scheme” that pays dividends without having actually realised value.
 
He pointed out that fair value accounting is merely a journal entry, not a real cash transaction, meaning the company has to borrow to pay the dividends. Little wonder that the end result is an outraged American public angry with Wall Street executives paying themselves huge bonuses out of fair value profits and with the subsequent massive government bailouts justified by reasons like “too big to fail”, leaving American tax payers to hold the bag.
 
Alternative Accounting
So if fair value accounting in its current formulation helps to create bubbles and pro-cyclical pressure, what is the alternative? Surprisingly, the solution might come from a quarter of the financial industry not exactly the most well-known for stability and transparency: hedge funds. Penman observed that while hedge funds employ fair value accounting, there are controls.
 
For example, when there is doubt about the value, the fund gets locked up or side pockets that cannot be traded are established until the uncertainty is resolved. The moral of the story as Penman puts it is: “Let’s not recognise value-added in business until you get or realise value. Don’t trade until there is resolution of uncertainty.”
 
One instance of appropriately applying fair value accounting is when shareholders’ value varies one-to-one with market price. For example, if you hold a bond and the price of the bond goes up, fair value is appropriate as your wealth is directly tied to the movement of market prices. However, for most businesses, including lending and borrowing banks, value comes not in the trading on prices but rather from trading with customers.
 
If a steel company holds a pile of coal, it does not actually make money if the price of coal goes up. It does so by feeding the coal into the blast furnace where steel is produced, and then, with buyers found, finally recognising value from the output price of selling the steel and the input price of buying coal. In other words, most businesses do not get value from exit prices but from arbitraging input and output market prices. To them, exit price is only the revenue, and not profit.
 
Fair value is also appropriate if you have a matched balance sheet. According to Penman, the common misconception about fair value accounting is to focus on updating old costs and getting the balance sheet right to indicate asset value. However, it is not possible to recognise a loss or gain on an asset without recognising loss on the associated liability.
 
Accounting for Loans
When it comes to loan accounting, Penman proposes the following steps. First, the bank makes the loan, but records the loan at historical transaction amount. Then for a few years, it simply recognises or records interest income at the risk free rate until creditworthiness has been established.
 
Only when the customer’s credit worthiness has been established by indicators that the bank had previously laid down – such as when the customer has been keeping up payments and customer’s income is going up – does the bank then recognise the difference between the risk free rate and the loan rate.
 
Noting that banks are in the business of making money by exposing themselves to credit risks, Penman’s suggestion is that they should thus only recognise and book the credit premium when uncertainty about collection has been substantially reduced, and amortise the income over the number of years as they make money on the credit risk with customer performance.
 
That way, instead of recognising value speculatively through fair value accounting and taking the hit when the customer cannot follow through, the bank adheres to strict accounting standards, where value is not recognised until the customer has performed.
 
Penman acknowledged that his idea is “very conservative accounting”, which probably will not sit well with the risk-taking culture of many finance hot shots – the same people who helped agitate the recent crisis. “For most loans that are not growing, it wouldn’t make much of a difference, but in a growing business, it makes a difference – such as lending to more sub-prime people,” he said.
 
Hopefully, there is no need for another crisis before lessons like these sink in.
 
About the Author
[email protected] is an online resource that offers regularly updated business insights, information and research from a variety of sources, including interviews with industry leaders and Singapore Management University faculty. The resource can be accessed at http://knowledge.smu.edu.sg. 
 
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