GAAP and IFRS

A Little Fair Value Never Killed Anyone

Fair value accounting became very hard work as the credit crisis dried up once-liquid markets, SEC panelists largely agree, but it should not be bl...
Tim ReasonJuly 9, 2008

Fair value accounting received a baptism by fire when it was rolled out at the beginning of the credit crisis. And it bedeviled financial institutions that had to find prices for securities no one would buy. But fair value remains the type of financial information investors find most useful, concluded a panel of experts assembled today by the Securities and Exchange Commission.

Any talk of suspending fair value accounting, most panelists agreed, risked ignoring real economic problems and plunging the U.S. into a “lost decade” similar to that experienced by Japan when that country did not acknowledge widespread liabilities within its banking system.

The panel, devoted to the issues facing large financial institutions, was the first of two on the topic of fair value hosted by the SEC this morning (a second panel was devoted to “all public companies”). For the most part, the first panel was comprised of fair value proponents.

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Fair value “is the most valuable information, particularly in tough markets, because it tells investors what is under stress,” said Kurt Schact of the CFA Institute in his opening remarks. “Where fair value has not lived up to its full potential is in the level and quality of accompanying disclosures.”

Loews Corporation CEO James Tisch, who was effectively the sole voice of dissent on the first panel, complained bitterly that fair value accounting required reams of nearly incomprehensible disclosure information and often forced his company to make poor economic choices.

Tisch began his remarks by complaining that under fair value accounting, companies holding securities that are hurt by rising interest rates must write them down unless the company states its intent to hold them until they mature. That, he said, forces companies into a “Hobson’s choice of ‘impair today or state an intention to hold to maturity.’” For companies such as Loews, which owns a large property/casualty insurer, he said, “the effect [of rising interest rates] will be to lock up large portions of insurance company portfolios,” forcing companies to make “sub-optimal portfolio decisions.”

Tisch added that Loews’ 10K statement is now 250 pages and has become “a document written by lawyers and accountants for lawyers and accountants.” He said that if insurance companies had to run mark-to-market accounting through their income statements, “it would essentially be out of business. The income statement would be totally meaningless.”

“I know this is not going to be good news to you,” the International Accounting Standards Board’s Jim Leisenring told Tisch, “but I hope you understand some parts of the world do what you say would be disastrous [to do].” Moreover, said Leisenring, who appeared on the panel as an observer, IASB currently has a proposal out for comment that says insurance liabilities should be at fair value.

Tisch also butted heads with Financial Accounting Standards Board observer Tom Linsmeier after Tisch claimed that the credit crisis had resulted in brokers quoting unreliable prices. Loews’s insurance portfolio includes some 6,000 different types of securities, said Tisch, and “we have a lot of trouble getting valuations” for about 20 percent of them. When forced to turn to pricing services or brokers, he said, “The market price [we got] is not reflective of anything other than a number that somebody just happened to throw on the table.” Moreover, he said, there are times when brokers take advantage of companies seeking valuations, and the resulting quote “reflects the price from a buyer who knows he is buying from a reluctant seller.”

“FAS 157 does state that you need to use a fair value that would be the exchange price in an orderly market,” Linsmeier responded. But when quoted prices seem unrealistic, he added, a company must do extra work and research to make adjustments to those quotes. “It is not acceptable to just accept a price that you know is not right for fair value,” he sternly told Tisch.

At that point, outgoing SEC commissioner Paul Atkins jumped briefly to Tisch’s defense. If brokers are quoting incorrect prices, “Then, as an issuer, what are you supposed to do?” he asked. “That’s the issue: accounting standard setters are setting up rules that may not be able to be followed in the field.”

Not so, said Linsmeier. “If a dealer is throwing out a price that is not what you believe the price to be, then [FAS] 157 says what you need to be doing in those circumstances. You need to move to a model. It is more work, but 157 tells you what to do.”

“Yes, there are markets that are more illiquid, but that just means you have to work harder,” agreed Matthew Schroeder, Goldman Sachs’ managing director of accounting policy, who described fair value as the “oxygen” of his firm. He also noted that from time to time Goldman will tell its traders to sell small pieces of its holdings “to get a sense of where the market is. We do that for price discovery.”

Bank of America CFO Joe Price supported fair value accounting during the panel, but did agree with Tisch that quotes from the market were not always reliable, a problem a company could even experience internally. “You assign a book to an internal trader, he wants it marked as low as possible,” said Price. “Don’t forget how he’s compensated.”

Price echoed the majority of the panelists who said determining fair value was hard, challenging work, but implied that the bigger challenge was selling the results to auditors. “You know there is a path to get there, as long as you can use professional judgment and not be second guessed and challenged on everything.”

“The challenges faced by auditors are consistent with the challenges faced by the companies they audit,” responded PricewaterhouseCoopers’ Russell B. Mallett III, the lone representative of the audit industry on the panel. He said audit firms had worked hard to supplement the general guidance from the Public Company Accounting Oversight Board with on-the-ground experience gained while auditing valuations of illiquid securities made by their clients.

Price, who was the only CFO on the panel, delivered a consistent defense of fair value accounting, but he did include one significant qualifier as he finished his opening remarks. “We are strongly opposed to the use of fair value for non-contractual liabilities, most notably litigation,” said Price. Indeed, Bank of America’s deputy general counsel, David Onorato, was one of more than a dozen corporate attorneys who signed a December 2007 letter to FASB and IASB warning against any attempt to require companies to estimate the future liability of pending lawsuits. FASB has since released an exposure draft that would require significantly expanded disclosure about potential legal liabilities, but stops short of requiring that companies determine a fair value for them. Despite that, Price’s careful caveat suggests that companies still fear that standard setters will ultimately attempt to impose such a requirement — possibly as U.S. GAAP gives way to International Financial Reporting Standards.

Near the close of the panel, SEC chairman Christopher Cox asked each panelist to discuss whether fair value accounting — particularly when applied to so-called “Level 3” assets for which there is no active market — had had a “pro-cyclical effect.” In other words, had the accounting exacerbated the country’s current economic woes by forcing already wobbly banks to take huge writedowns? “I think you could have the exact same problem [using] historical cost,” said Michigan State University accounting professor Kathy Petroni.

“It is not the cause of the cycle, it is not a perpetuating factor, it is simply telling the market what it is experiencing,” said CFA Institute’s Schact. “If you look at the alternative [of ignoring the banking industries current woes],” added Goldman Sachs’s Schroeder, “I think it is less pro-cyclical.”