Fair Value Accounting Works Well, but Is Not Perfect

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Both those who prepare and those who use financial statements increasingly question the efficacy of fair value measures, which require companies to account for assets and liabilities at current market values. Debate about the usefulness of fair value has increased as illiquid and volatile markets have recently highlighted the practice’s weaknesses—including uncertainties about whether necessary write-downs are too conservative or too aggressive, whether valuations are timely, and whether companies have too little discretion in setting the parameters and estimates used to value assets.

S&P President Deven Sharma pointed out the benefits and drawbacks of fair value accounting: “In our view, financial statements should endeavor to portray the underlying economic position of a company, and fair value reporting should reflect this fundamental principle. … However, as you will likely discover, this concept is not that simple.” While fair value accounting is not a one-size-fits-all solution, Sharma said it is a useful part of a larger whole, a sentiment echoed by many of the forum’s panelists.

“We support fair value accounting—we think it’s relevant, we think it’s meaningful,” said Bob Traficanti, deputy controller and head of corporate accounting policy at Citigroup Inc. “It has worked for a long time, and it will continue to work,” but at the same time, he said, the current market has made for some unintended consequences and unrealistically low values on some securities. “What kind of default rates would you have to get to make those values real?” he asked. “In some cases, it doesn’t make any sense.”

Many commentators have pointed to the tendency of fair value accounting to create a spiral of diminished values—so-called pro-cyclicality—as forced asset sales exacerbate declines. Some panelists also added that efforts to better gauge what assets are worth in the absence of available market prices are often met with resistance, or worse, great skepticism.

“Fair value is here—it’s the right standard in a lot of contexts,” said David Johnson, executive vice president and outgoing CFO at The Hartford Financial Services Group Inc. But, he added, it’s also time to let those making valuations do so outside an environment of fear. “Anybody who wants to exercise judgment is going to be mowed down if they’re the slightest bit wrong in hindsight,” Johnson said, adding that he also sees a need to supplement fair value with uniform alternative disclosures and consistent, auditable rules for other disclosures.

Much of the ensuing discussion focused on the lack of transparency arising from companies’ valuations of their own debt, as well as on SFAS 157, Fair Value Measurements, the accounting rule that took effect in the first quarter of 2008 for most companies and detailed how to value financial assets and liabilities. FASB Chairman Robert Herz acknowledged that market illiquidity can be caused by factors unrelated to deteriorating credit quality, and it can be problematic. Nonetheless, Herz said, “Illiquidity needs to be recognized as an economic reality and accounted for when it arises, no matter the underlying cause.” Herz added that fair value accounting has been complicated by the “multiple waterfalls” of structured finance and would benefit from
“a lot more clarity and robustness about disclosures.”

The current environment suggests that the infrastructure of some companies with regard to pricing needs attention, noted Raymond Beier, a partner of PricewaterhouseCoopers LLP. He also noted that, in part, accounting complexity exists because doing business is increasingly complex, and that solutions need to be sought “on a holistic basis.” “Business today is complicated,” Beier said, and “companies didn’t have systems that gave them the information that management needed.”

Addressing how fair value affects the interplay between accounting and risk management, Alexey Surkov, a partner of Deloitte & Touche LLP, said the current environment highlights a “disconnect between the risks as they manifested themselves in the marketplace and traditional risk-management techniques.”

“In the absence of liquid markets, clients had to go to other ways to determine fair value,” Surkov said, adding that “as the values that are coming out of the marketplace guide us in determining the values of our portfolios, we may need to use models to interpolate ... those values.” Meanwhile, he said, there is “still a gap between those market players who had models in place and those who had to start from scratch.”

At the same time, said Esther Mills, managing director at Morgan Stanley and chair of the accounting and tax subcommittee at the American Securitization Forum, “the greater application of fair value has helped bring accounting and risk management into alignment. … Where there’s room for improvement is to do more in the area of explaining the range of values and sensitivities.”

Most panelists agreed that better disclosure of the methods used in valuation—and what might affect those valuations—is an essential part of financial statements. “I don’t think you can come up with an accounting method that doesn’t require good disclosure” to explain valuations, said Alan Beller, a partner of Cleary Gottlieb Steen & Hamilton LLP. “Good disclosure trumps bad accounting.”

But more isn’t always better, some panelists said, decrying disclosures that are often more like boilerplate, as well as disclosures that confuse more than clarify.

S&P’s Views on Fair Value

Standard & Poor’s ratings service supports the premise that fair value, when coupled with robust disclosure, is a relevant basis of accounting for financial assets and liabilities. In S&P’s view, the challenges associated with fair value can be overcome only by recognizing that translating the complexity of an economic event into a single number—no matter the basis for measurement—is impossible.

Consequently, according to S&P, “additional instructive disclosures and greater transparency around fair value measures are essential.” The ratings service recognizes, however, that accounting for assets and liabilities at theoretical market price measures can mask the underlying economics for certain businesses and activities, especially under volatile and uncertain economic and market conditions. According to S&P. To meet users’ needs, companies should disclose the underlying risks, valuation methodologies, assumptions, volatility, market adjustments and sensitivities, and other factors.

While S&P supports fair value accounting for financial instruments, it believes certain refinements should be considered. These include allowing greater emphasis on entity-specific (rather than market-based) information when market observations are substantially lacking or influenced by temporary market disruptions, coupled with clear footnote disclosures regarding market values when market transactions exist but the company has elected not to use them, or when the company has modified them for valuing its positions and the reasons for doing so.

Because there is a need for a consistent benchmark in lieu of an unrealistic one-size-fits-all solution, S&P supports a common, comprehensive, and agreed-upon framework using fair value for financial instruments as the next-best solution.

For more of S&P’s views on fair value accounting, see “Is It Time to Write Off Fair Value?,” S&P’s Ratings Direct, May 27, 2008.

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