The Fair-Value Blame Game

Fallout from the credit crisis has put mark-to-market accounting to the test.
Sarah JohnsonMarch 19, 2008

Despite the beating fair-value accounting has taken from financial-services firms that have absorbed huge write-downs, the concept of mark-to-market valuations is here to stay, according to David Tweedie, chairman of the International Accounting Standards Board.

Tweedie predicts that fair value will be applied to all financial instruments some day — long after he has left the IASB, he told To the fair-value dissenters who claim recent valuations are creating unfair, negative pictures of the value of their assets, he asks whether they offer any alternative solutions. Going back to the traditional method of historical cost is not going to work, he says.

Under fair value 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 about what value they believe a hypothetical third party would place on those assets.

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“Fair value in a time of crisis can in effect exacerbate the concerns about a situation. But on balance, fair value keeps the situation honest,” Tweedie says. In fact, without fair-value accounting, investors would not now be realizing the true worth of the mortgage-backed securities that have led to the write-downs at various firms, he confirms. The use of fair value forces the true downsides of a company’s investment — such as securities tied to bad lending practices — to come to fruition.

In recent weeks, financial services firms have blamed their financial troubles on the use of fair value. Perhaps the most vocal has been Martin Sullivan, CEO of American International Group. The insurer recently reported $11 billion in write-downs, and has called for changes in the accounting rules.

“We are trying, as are many others, to value very complex instruments,” Sullivan told investors during a conference call in February. “These valuations are not mechanical. They involve difficult estimates and judgments. I can tell you that we have, at all times, brought our best judgment to bear in making these valuations.”

To be sure, critics of fair value say that it can distort market realities by giving management too much discretion and room for abuse. But the proponents say it actually creates transparency by reflecting the up-to-date reality of an asset’s or liability’s worth.

Corporations that have made poor decisions lately are using fair value as a “scapegoat,” according to the CFA Institute Centre for Financial Market Integrity, a research and policy organization. “Fair value accounting and disclosures, which provide investors with information about market conditions as well as forward-looking analyses, does not create losses but rather reflects a firm’s present condition,” says Georgene Palacky, director of the CFA’s financial reporting group.

Indeed, Tweedie deflects the current fair-value criticisms as ignoring the true roots of the current problems in the financial marketplace. “The real problem in the current crisis is a lack of trust and lack of transparency,” he says.

The IASB further defends the use of fair value in a discussion paper about reducing complexity in reporting financial instruments, released on Wednesday. The 98-page document was in the works long before the credit crisis hit; however it comes at an opportune time for the supporters of mark-to-market accounting.

In it, the IASB says fair value “seems to be the only measure that is appropriate for all types of financial instruments.” Still, the board acknowledges that “there are issues and concerns that have to be addressed before [rule-makers] can require general fair value measurement.”