Illiquid Markets Rock Fair-Value Accounting

The philosophy of fair-value accounting has been put through the ringer in the first few months of 2008, as turmoil in the financial markets compelled banking executives and trade groups to question its reliability.

They claim the use of fair value for assessing financial instruments has led to volatile income statements, and the growing number of billions-dollar-plus write-downs for financial services firms. Bankers would prefer the option of being able to use both fair value and historical cost calculations — the latter of which is being phased out by accounting standard-setters in their push for the widespread use of fair value. (They do not yet require nonfinancial assets to be measured that way, however).

In a report released this week, Fitch Ratings discourages the idea of allowing financial instruments to be measured using a mixed-attribute model, even in illiquid markets. Indeed, accounting rules require companies to stick to their measurement methods from the get-go; if a company decides to use mark-to-market accounting for an asset one year, it can't backtrack and measure it using historical cost the next.

Rather than try to stop the use of fair-value accounting, firms should improve their disclosures to help investors understand the limitations of their estimates, Fitch says. Otherwise, the agency implies, "unfettered flexibility" in accounting could hamper investor confidence and infringe on the stability of capital markets.

Outside of financial services firms, there are plenty of fair-value supporters. Investors and analysts dispute bankers' complaints about fair value; from the market's standpoint, it actually helps them better understand the latest and truest worth of a firm's assets and liabilities. Moreover, the rating agency contends that the worthiness of fair-value measurements comes when they provide "realistic and reliable" indicators of the net present values of a company's future cash flows.

At the same time, Fitch acknowledges the task of fair value accounting isn't easy. Under the rules, companies measure their assets and liabilities based on an existing market or — in the case of assets that are traded thinly, or not at all — on unobservable estimates based on what value they believe a hypothetical third party would place on those assets. During times of illiquid market conditions, the prices used as benchmarks for these inputs "may be a distorting rather than a helpful factor" when calculating fair value, according to Fitch.

The agency suggests that companies explain their reasoning behind the inputs they do use. If they have not plugged in the best observable data to come up with their assessments, they should show why their measurement choice was more appropriate.

What Fitch's recommendations boil down to is for companies to explain their judgment calls in order to ensure fair value accounting's success and investors' comprehension. "When market liquidity has dried up, resulting in market prices that tell little about future cash flows of an entity that can hold onto an asset, clinging onto a strict interpretation of rules rather than exercising judgment can make a nonsense of financial reporting," Fitch says.