Accounting & Tax

A Fair Value Pep Rally?

Critics are conspicuously absent from this week's SEC roundtable on fair value accounting. So what is it that its participants hope to accomplish?
Tim Reason and David KatzJuly 7, 2008

In two days time, the Securities and Exchange Commission will host a roundtable on fair value accounting and auditing standards — that is, the increasingly mandatory practices of valuing the assets and liabilities of companies, and ultimately companies themselves, by their current worth in the marketplace.

That’s a controversial topic, given the difficulty of finding market prices for many features of modern corporate finance, and the fact that some of those mandates seemed to have rolled out around the same time that the credit markets crashed. But this discussion promises to be a more congenial affair than past SEC roundtables — notably a 2005 roundtable on section 404 of the Sarbanes-Oxley Act, in which many participants were openly hostile about the topic. Indeed, this week’s roundtable may more closely resemble the follow-up roundtable held in 2006, when most participants had accepted 404, reluctantly or otherwise, and focused on calling to the SEC’s attention small changes that would ease their compliance efforts.

The first panel of this week’s fair value roundtable is devoted to the “perspective of larger financial institutions and the needs of their investors.” But it is conspicuously devoid of large financial institutions that have been complaining about being forced by fair value accounting to take huge write-downs, including Citigroup and Merrill Lynch, and not to mention Bear Stearns. Also missing are prominent campaigners against fair value, such as Blackstone Group co-founder Stephen Schwarzman, who just last week sounded off about what he perceives as the dangers of FAS 157 to The New York Times.

Drive Business Strategy and Growth

Drive Business Strategy and Growth

Learn how NetSuite Financial Management allows you to quickly and easily model what-if scenarios and generate reports.

Long-term observers of sea changes in finance and accounting rules will find no coincidence in the sudden flurry of mainstream media attention to arcane accounting rules — clearly a battle is brewing. The Schwarzman story was one of three accounting stories with fair value angles that appeared in the Times in the first six days of July.

But likewise, there’s a message to be read in the makeup of the SEC’s panels. It suggests the roundtable will be a nuanced discussion — the broad application of fair value accounting itself does not seem to be up for debate. The panel devoted to large financial institutions is stacked with fair value proponents. That includes Bank of America CFO Joe Price, who delivered a defense of fair value at a Federal Reserve Bank of Chicago conference in May. Noting that the financial industry’s current woes are probably more attributable to poor risk assessment than accounting changes, Price said, noting that mark-to market accounting is “an important component” of risk control. “In fact,” he added, “the accounting is more likely making that risk more transparent.”

Price did note that “There’s no question we’re testing a much more market-based accounting process for certain expanded business activities for the first time in a hard disruption, so it is inevitable that we re-examine and improve it.”

Joining price on the panel is Kurt Schact of the CFA Institute, a staunch defender of fair value. And while the private equity world’s Schwarzman didn’t make the cut, Jane B. Adams of hedge fund Maverick Capital did. She’s on record as supporting the CFA’s positions on fair value and serves as member of the group’s Corporate Disclosure Policy Council.

Also on the panel is Goldman Sachs’ managing director of accounting policy Matthew Schroeder. Goldman weathered the credit crisis particularly well, a stroke of good fortune that many observers attribute to the firm’s long-standing practice of marking its books to market, and its conservative stance as the credit markets began unraveling.

Academic Kathy Petroni of Michigan State University, also on the first panel, is the co-author of papers insisting on fair value’s relevance for valuing companies. Rounding out the panel are Russell B. Mallett III, of PricewaterHouseCoopers (which is on record as being largely supportive fair value), and James S. Tisch, CEO of Loews Corporation. The latter runs a conglomerate that is more of an investment firm that an operating entity — Loews, indeed, is something of an expert shop when it comes to using fair value to analyze acquisitions.

The second panel, focusing on the perspective of “all public companies,” seems equally weighted toward a pro-fair value stance. For example, panelists Harold Schroeder of Carlson Capital appeared at a CFA Institute panel discussion on fair value this spring and took the sanguine view that the credit crunch would ease on its own.

Yet this may be the panel to watch to see some powerful interests make some subtle points about fair value. Panelist Leonard Cotton, vice chairman of Centerline Capital Group, is also the president of the Commercial Mortgage Securities Association. Watch for him to agree that fair value is no problem, but also push to rehabilitate the damaged securitization market by repeating the CMSA’s insistence that valuation of securitization bonds has been hampered because the market is using incomplete information.

“We believe the volatility in the CMBX index caused by momentum traders, rather than fundamental traders, distorts the true picture of the value of CMBS bonds,” he said in an April statement. ““Given the role the Index has come to play in determining the ‘mark-to-market’ value of securities held by financial institutions in the current market environment, greater transparency on CMBX trading volumes and the number of daily trades would aid investors in assessing the merit of values as indicated by the Index.”

Cotton is not alone among panelists as likely defenders of securitization: In the first panel, Goldman’s Schroeder is an active participant in the American Securitization Forum’s efforts to converge U.S. and international securitization accounting.

Watch, too, for any possible comments on the question of professional judgment and fair value. The SEC’s Committee on Improvements to Financial Reporting has proposed creating a professional judgment framework that would give companies and their officers guidelines applicable to many areas of accounting, but notably fair value judgments. Writ large, this is essentially a shield against class-action lawsuits, which some fear could balloon if corporations are forced by fair value rules to include more subjective estimates in their financial statements. A keen observer would do well to remember that SEC chairman Christopher Cox himself is no fan of class-action lawsuits against companies and was the original author of what eventually became the Public Litigation Securities Reform Act.

Sitting in on both panels as an “observer” is James Leisenring, an outspoken member of the International Accounting Standards Board. While the panel also has observers from FASB and the PCAOB, Leisenring’s presence could suggest annother possible issue to be raised: the definitions of fair value of FASB and the International Accounting Standards Board differ markedly.

That’s crucial, since the SEC’s parallel — and overarching — goal to fair-value accounting is to converge on a single set of accounting standards. But as it points out in Reducing Complexity in Reporting Financial Instruments, a comment paper it issued in late March, IASB’s definition, contained in IAS 32, Financial Instruments: Presentation, “refers to an exchange price without specifying that it is the price at which a holder or debtor could sell or transfer its financial instrument. Therefore, that definition could include the price at which a comparable asset could be acquired or a comparable liability could be incurred or settled.”

But FASB’s Statement No. 157, Fair Value Measurements, on the other hand, is more specific. It defines fair value as an exit price: “the price at which an instrument could be sold or transferred in an orderly transaction,” according to the invitation to comment. While both standard-setters agree on the principle of converging on a single accounting regime based on fair value, the differing definitions of fair value could prove complicated.