Fair Value: It’s the Disclosures, Stupid

A former regulator and veteran CFO contends that too many critics are "missing the boat" when they argue against fair-value accounting.
Marie LeoneNovember 20, 2008

A former member of the Federal Reserve Board of Governors and a one-time bank CFO, Susan Schmidt Bies looks at fair value from two sides of the debate — and she thinks “people are missing the boat.” Speaking at an industry conference this week, Bies asserted that “the focus is disclosure,” adding that investors, regulators and other financial-statement users aren’t fixated on a single fair-value estimate. Rather, they want to understand “the key drivers behind fair-value estimates,” she said.

Bies admitted that before the credit crisis took hold, companies were forced to meet their projected earnings estimates dead on and could be punished with a share-price drop for missing by a penny. She said, however, that it makes sense to reveal what goes into the key metrics that a company touts to the public because it is a much broader swath of information, and a slight deviation becomes easier to explain when put into the proper context.

In her talk, she counseled companies and regulators to educate constituents in risk metrics and fair value as a way of presenting a more complete picture of a company’s performance and managing corporate performance expectations for the long term.

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Bies acknowledged that banks and other companies worry that fair- value accounting “eats away at capital.” But she has a problem with the way some companies avoided fair-value accounting and proper disclosures to hide the economic reality of transactions. “My problem was with companies that accepted unrealized gains [and] called it capital, and then leveraged it 40 times over,” she said. “The unrealized gains [were] phantom gains.”

The former Fed member noted that the renewed emphasis on fair-value accounting may add impetus to reforming a regulatory system that is “broke.” She pointed to two instances that are fast becoming classic examples of the breakdown: AIG and its quagmire of unsettled credit-default swaps and the failure of Lehman Brothers, which crashed primarily because of massive exposure to collateralized debt obligations.

Bies reckoned that at the very least, the global CDO markets need a central clearinghouse to bring settlement into the open. She also used the collapse of Bear Stearns to underscore the problem inherent in making the U.S. Securities and Exchange Commission the primary regulator of investment banking.

By her lights, it’s wrong to expect that a watchdog trained on investor protection should also have to focus on a bank’s liquidity position. It is not the SEC’s job to focus on “the safety and soundness” of banks, said Bies. Yet in the future, banking and investors regulators will have to work together to bridge the regulatory gap, she added.