Mark to Market Watch

No Fair

The verdict on fair value accounting: guilty.

By 12.22.08

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Many of us argued against Financial Accounting Standard (FAS) 133, a big step on the downhill path of "fair value" accounting ten years ago, finding it not only wildly convoluted and expensive, but conceptually wrong. The more criticism the Financial Accounting Standards Board (FASB) got, the more they dug in.

At the time, this led me to develop a two-part plan for the FASB. Part one: tar. Part two: feathers.

Unfortunately, this plan was not implemented. FASB was able to continue on its metaphysical quest for "fair value" accounting up through FAS 157 (so far), enabling it to be an important factor in making the financial panic of 2007-08 worse -- "a major cause of the world-wide financial crisis," as Bill Isaac recently observed.

A FASB defense against this indictment claims that "Fair value reflects losses that have been incurred, it does not cause losses." But in a downward spiral of panic and illiquidity, this is manifestly untrue. Accounting has real world effects on funding markets, including heightening international uncertainty and triggering defaults on debt covenants, customer behavior, and the actions of regulators. All this creates further uncertainty, which further depresses prices.

The perverse effects of fair value accounting in a market panic are why almost all financial institution regulators oppose it. It is too easy for them to think of distressed situations which the banking system survived, but would not have survived if it had had to "mark to market" at the time. The 1980s and 1974-75 are good examples.

Apologists for FASB and fair value accounting also say they are only insisting on "the facts" of market prices, although of course admitting that in many cases there is no active market or no market at all, and that panicked markets can reach fire sale prices that will be judged by later observers as irrational. Nonetheless, they say, we must not hide from "the truth."

But what is accounting truth? It is never and never can be simply "the facts." It is facts treated according to some theory, which also generates the projections, estimates and guesses needed to calculate what the theory defines as its results -- for example, the defined concepts of "profit" and "capital." As the Institute of Chartered Accountants of England and Wales so rightly observe: "Financial reporting attempts to measure inherently abstract and debatable concepts such as income and net assets, and it has particular features that make it to some extent inevitably subjective."

Debatable indeed: accounting theories are debated over years and decades without one side or the other being demonstrated as correct.

So what kind of a theory is fair value accounting when applied to debt instruments? It is okay in a stable period when prices are equilibrium-seeking. But in a period of dynamic disequilibrium and discontinuity, like a panic, it adds to the disequilibrium and makes the problems worse.

An essential distinction is that debt instruments, unlike equities (or houses), have a principal to be repaid at maturity, and contracted-for interest payments until then. Suppose all interest and principal are going to be paid exactly as agreed. What is the right accounting representation? This is the same question as asking what discount rate should be applied to the cash flows of interest and principal and how that should affect the defined concepts of profits and capital. To discount the cash flows by the exaggerated illiquidity premiums of a panicked market, then by doing so to produce losses and erase capital, is to feed the panic.

Many right-minded observers therefore say we should "suspend" fair value accounting. This seems to me to give it too much credit, to merely ask for a mulligan. I say it should not be suspended, but fixed.

Here's how. Produce pre-"fair value" balance sheets and income statements as before. Then add as a new principal financial statement a completely "marked to market" balance sheet, showing the "truth" according to fair value theory, using whatever market prices there are or are estimated to be. This would give the proponents of fair value accounting all the information they desire. It would not be "buried" in the notes, a typical complaint, but added to the set of key financial statements, which would become:

     -Balance Sheet

     -Statement of Income

     -Statement of Shareholders' Equity

     -Statement of Cash Flows

     -Marked to Market Balance Sheet.

Thus we would have multiple perspectives on asset values, just as cash flows and accrual accounting are multiple perspectives on operations. But we wouldn't have accounting feeding the downward spiral of a panic (or for that matter, helping inflate a bubble).

Faced with the current effects of its fair value theory and consequent criticisms, the FASB has redoubled its commitment to the theory and announced it wants to take it even further. Thoughtful government policy makers are unlikely to share the view that "I must follow my accounting theory, though the heavens fall." Somebody needs to simply overrule FASB. If the SEC won't do it, then who? Well, FASB is a government-sponsored entity, which ultimately works for and has its funding mandated by Congress.

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About the Author

Alex J. Pollock is a resident fellow at the American Enterprise Institute.