The Routledge Companion to Fair Value in Accounting

Gilad Livne, Garen Markarian, Gilad Livne, Garen Markarian

• Publisher: Routledge
• Year: 2018
• ISBN:
  9781317221319
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Contabilidad financiera

The concept of "fair value" marked a major departure from traditional cost accounting. In theory, under this approach a balance sheet that better reflects the current value of assets and liabilities. Critics of fair value argue that it is less useful over longer time frames and prone to distortion by market inefficiencies resulting in procyclicality in the financial system by exacerbating market swings.

Comprising contributions from a unique mixture of academics, standard setters and practitioners, and edited by internationally recognized experts, this book, on a controversial and intensely debated topic, is a comprehensive reference source which:

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• examines the use of fair value in international financial reporting standards and the US standard SFAS 157 Fair Value Measurement, setting out the case for and against

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• looks at fair value from a number of different theoretical and practical perspectives, including a critical review of the merits and arguments against the use of fair value accounting

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• explores fair value accounting in practice, involvement in the Great Financial Crisis, implications for managerial reporting discretion, compensation and investment

This volume is an indispensable reference that is deserving of a place on the bookshelves of both libraries and all those working in, studying, or researching the areas of international accounting, financial accounting and reporting.

1
DOES THE USAGE OF FAIR VALUES INCREASE SYSTEMIC RISKS?

Alan Ball and Andrew Haldane

Introduction

In 2008, the global financial system experienced a dramatic thunderstorm. Lightning strikes threatened seizure in some financial markets and institutions, and, nearly a decade later, the rumbles of thunder are still discernable.

The debate on the causes and consequences of this perfect storm have been subject to considerable debate, but at the center of this storm is, on the face of it, a rather basic question: how should the instruments that make up the financial system be valued? So basic a question ought not to be a matter of life and death. But for a great many financial institutions during this crisis, it was precisely that.

The fundamental concept on which this debate hinges is fair value. Like beauty, its meaning lies in the eyes of the beholder. For some, the application of fair value principles risks exposing financial firms to the vagaries of markets. For others, ignoring the signals from financial markets risks creating a financial landscape that is anything but fair.

The fair value debate generates electricity in the usually static-free professions of accountancy and regulation. Bankers fulminate at the mere mention. Among Heads of State in some of the biggest countries in the world, accounting standards for derivatives have generated levels of fear and consternation usually reserved for non-financial weapons of mass destruction.

Three phases of fair value

So, what lies at the heart of this debate? It is well captured by Preston Delano, US Comptroller of the Currency:

…the soundness of the banking system depends upon the soundness of the country’s business and industrial enterprises, and should not be measured by the precarious yardstick of current market quotations which often reflect speculative and not true appraisals of intrinsic worth.¹

Delano was US Comptroller of the Currency in 1938. This provides a clue to the fact that the fair value debate is not a new one. To understand this debate, its origins and undulations, it is worth starting at the very beginning.

Although bookkeeping has far earlier antecedents, modern accountancy is believed to have begun in the Italian cities of Genoa, Venice and Florence in the 14th century. It is no coincidence that modern banking emerged at precisely the same time in precisely the same cities. Banks emerged to service rapidly expanding commercial companies, and double-entry bookkeeping became an essential means of recording and tracking who owed what to whom, oiling the wheels of finance.

It is no coincidence, too, that the first-known description of accountancy was provided by an Italian, Luca Pacioli, in the late 15th century.² Pacioli was not your typical accountant. A wandering Franciscan monk, tutor and mathematician, he was a friend, and sometimes collaborator, of Leonardo de Vinci. Although comfortably the less famous of the two, Pacioli is still known today as the father of modern accounting.

From those beginnings, double-entry bookkeeping began to spread north within Europe during the Middle Ages: to Germany in the 15th century, Spain and England in the 16th century and Scotland in the 17th century. By the late 18th century, Goethe had called double-entry ‘among the finest inventions of the human mind’.³ Some people are easily impressed. Despite that, the progress of double-entry was surprisingly slow. At the start of the 19th century, there were only 11 Londoners who listed their occupation as ‘accomptants’.

The 19th century marked a turning point. In the UK, joint stock companies began to spring up. The Bankruptcy Act of 1831 gave accountants a role in winding-up enterprises, and the Companies Acts of 1844 and 1862 established a legal requirement for companies to register and file accounts. By the end of the century, audit practices were becoming established. The accountant’s role was to provide a true and fair view of a company’s assets and income, as protection for the state (to whom it paid taxes) and investors (to whom it paid dividends).

It was these concerns that led to the gradual emergence during the second half of the 19th century of fair value-based accounting conventions in the USA. From the late 19th century, banks’ securities were carried at market values and their fixed assets at ‘appraised values’. In other words, by the early 20th century, fair value principles were widely applied to companies in general and to banks in particular. In many respects, this period may have been the high-water mark for fair value principles.

In the USA, this first wave of the fair value debate ended in 1938.⁴ The backdrop was inauspicious. The first phase of the Great Depression, between 1929 and 1933, saw the failure of a large number of US banks. Between 1933 and 1937, the US economy recovered somewhat, but by 1938, there were fears of a double dip. At the Fed’s prompting, Franklin D Roosevelt called a convention comprising the US Treasury, the Federal Reserve Board, the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC). Its purpose was to determine what should be done with prudential standards to safeguard recovery.

This was no ordinary regulatory convention. Marriner S Eccles, Chairman of the Federal Reserve, called it ‘guerrilla warfare’. In one corner were the regulators, the Comptroller of the Currency and the FDIC. Scarred by their regulatory experience, and fearing further bank failures, the Comptroller and the FDIC pushed for high prudential standards, including preservation of fair values for banks’ assets. In the other corner was the Fed. Scarred by their monetary policy experience, and fearing a further collapse in lending, the Fed argued for laxer prudential standards and the abandonment of fair values. Battle commenced.

The tussle lasted two months, often played out in public through The New York Times. In the end, the Fed prevailed. On 26 June 1938, Franklin D Roosevelt announced (without so much as a hint of irony) the Uniform Agreement on Bank Supervisory Procedures. Banks’ investment-grade assets were to be valued not at market values but at amortized cost. And banks’ sub-investment-grade assets were to be valued at a long-run average of market prices. In the teeth of crisis, and in the interest of macroeconomic stability, the first phase of fair value had ended.

This pattern was to be repeated half a century later – the second wave of fair value. Historic cost accounting remained in the ascendancy in the USA from the 1940s right through to the early 1970s. But from the mid-1970s onward, accounting standard-setters began to embrace fair value measurement, first in the context of banks’ portfolios of equities and other marketable securities.⁵ By the late 1980s, there was widespread recognition that traditional accounting approaches were obscuring the real value of securities and derivatives.

US experience during the Savings and Loan crisis in the mid-1980s provided further impetus. Forbearance, including about the valuation of assets and liabilities, was widely believed to have been a cause of the buildup of problems among the thrifts.⁶ In 1989, Congress passed the Financial Institutions Recovery, Reform and Enforcement Act, tightening valuation standards among banks and bringing them closer to fair values. In the same year, the International Accounting Standards Committee (IASC) commenced a project to assess the measurement and disclosure of financial instruments. These too were to suffer a setback.

By 1990, recession had taken hold in the USA, with lending contracting sharply. As in 1938, the US economy was suffering ‘financial headwinds’. As in 1938, the Fed was quick to call for a relaxation of prudential and valuation standards to head off pressures on banks.⁷ As in 1938, the upshot was a concerted move by the then-President, George H W Bush, relaxing examination and valuation standards.⁸ For the second time, fair value had been returned to its box.

And so, to the present day – the third phase. By 2008, the ranks of ‘accomptants’ had swelled, with numbers of recognized accountants in the UK totaling over 275,000. Yet, the issues raised by the global financial crisis had loud echoes of 1938. Through the 1990s, the main international accounting standard-setters extended the boundaries of fair value. In the USA, this was given impetus by the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991. Widespread use of mark to market was a key ingredient of the prompt corrective action approach embodied in FDICIA.

From 1992, it became a requirement among US companies to disclose the fair value of all financial instruments in the notes to their accounts. Toward the end of the 1990s, this move was formalized with financial instruments (derivatives, equity and debt) being included explicitly in the accounts at fair value. In the USA, this followed the adoption of the Statement of Financial Accounting Standard 133 in June 1998. Elsewhere, it followed adoption of the IASC’s International Accounting Standard 39 in January 2001.

The banking crisis brought that evolution to a halt. As pressures on banks’ balance sheets intensified, subdued lending growth raised concerns that recovery may be retarded. A debate began internationally on rolling back fair value to arrest this downward trajectory. Once again, central bank governors, politicians, regulators and countries were prominent in their criticism of fair value, leading to fears that fair value was poised to enter the third dip on its roller-coaster journey.

Fair values and market prices

What have been the underlying forces leading fair value to be at first lauded, then questioned and periodically abandoned? At the heart of this is the vexed question of whether market prices are a true and fair assessment of value.

In theory, market prices ought to be a full and fair reflection of the present value of future cash flows on an asset. This is the fulcrum of the Efficient Markets Hypothesis (EMH). Market prices, if not perfect, are at least efficient aggregators of information – a one-stop shop for appraising value. This simplicity makes EMH a powerful theory. But its real power is its widespread application in practice. EMH has not just monopolized the finance textbooks; it has also dominated the dealing rooms.

If the EMH were to hold strictly, the fair value debate would be uncontentious. Marking of assets to market would be proper recognition of their economic value. In that financial utopia, the interests of accountants, investors and regulators would be perfectly aligned. Accountants would have a verifiable valuation yardstick, investors a true and fair view of their true worth and regulators an objective means of evaluating solvency. Fair value would serve treble duty.

In practice, the fair value debate is contentious and has been for at least a century. Through history, accountants, investors and regulators have not always sung in tune. Today, accountants are singing opera Pacioli-style and regulators are rapping at 300 words a minute, while investors are left to whistle. In part, this discord has been blamed on failures of EMH, ‘the precarious yardstick of current market quotations’.

It should come as no surprise that fair value principles have faced their stiffest tests at times of crisis – the Great Depression during the previous century and the Great Recess...