G-20 Verdict on Fair Value: Innocent

The world's top finance ministers say that excessive risk-taking and sloppy judgments caused the crisis.
David KatzNovember 17, 2008

Advocates of fair-value accounting are breathing more easily following the declaration over the weekend by the Group of 20 concerning the state of the world economy and financial markets. The reason? Mark-to-market financial reporting was nowhere cited as a major cause of the collapse of financial institutions.

Those advocates have had to fend off arguments by bankers and other opponents of fair-value accounting that it had been a prime spark of the financial crisis, a “procyclical” irritant that had forced banks to sell distressed securities at fire-sale prices—thereby sending the value of those assets through the floor.

So vigorous has the opposition become that the threat of suspending FAS 157, the Financial Accounting Standards Boards’ controversial cookbook for marking assets and liabilities, still looms. Just after New Year’s Day 2009, for example, the Securities and Exchange Commission is slated to report on the results of a congressionally mandated study of the effects of 157 on the crisis. Opponents of fair value have suggested that Congress put a moratorium on the standard until the crisis ends.

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.

In this environment, both mark-to-market’s proponents and its enemies eyed the deliberations of the G-20 finance ministers and central bank governors with great interest. Prompted by fears that fair value was indeed procyclical, European governments had pressured the International Accounting Standards Board, heretofore a staunch advocate of mark-to- market accounting, to enable some banks to move assets from mark-to-market to historical-cost accounting, thereby avoiding billions of dollars of losses.

For that reason and others, the accountants and investors that favored fair value might well have been biting their nails before the G-20 meeting on Saturday. As it happens, they had no need to. In the declaration, the twenty ministers opined that the root causes of the current crisis include:

• The search for higher yields without adequate appreciation of the risks and a failure of oversight.

• An abundance of “weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage.”

•Policy-makers, regulators, and bank supervisors displayed a lack of appreciation of the build-up in risk, a lag in keeping pace with financial innovations, and an inability to foresee the effects of certain regulatory actions.

The declaration went on: “Major underlying factors to the current situation were, among others, inconsistent and insufficiently coordinated macroeconomic policies [and] inadequate structural reforms, which led to unsustainable global macroeconomic outcomes. These developments, together, contributed to excesses and ultimately resulted in severe market disruption.”

Noticeably left out of that list were accounting and financial reporting. “There’s tremendous consensus around the fact that [the crisis] has nothing to do with financial reporting,” said Patrick Finnegan, director of the financial reporting policy group of the CFA Institute Centre for Financial Market Integrity. “I don’t think financial reporting could be held accountable for judgments of these large financial organizations that took these risks.”

Speaking at a briefing on mark-to-market accounting held today by the New York State Society of Certified Public Accountants, Finnegan said that he was “very gratified” to see that the ministers placed blame for the crisis on “excessive risk taking [and] poor judgments” and not on fair-value financial reporting.

While the G-20 omission appeared to be a victory for mark-to-market reporting, fair-value concepts are still absorbing palpable hits from critics. At the briefing, Stephen Penman, a professor of accounting and security analysis at Columbia University who disagrees with many aspects of fair value—including attempts to apply it in illiquid markets and by companies that sell products with no direct relationship to financial markets—advised accountants and their clients of a fundamental tenet he subscribes to: “be careful about putting prices in your financial statements.”

The main reason for such caution is the possibility of an asset-price bubble, the professor said. In the recent real estate bubble, as in the tech and pension bubbles of the 1990s, marked-to-market assets turned out to be inadequate collateral for loans when the bubble burst, according to Penman.

After the 1929 stock-market crash, regulators “accused accountants of putting water in the balance sheet” by employing fair-value accounting, Penman said, noting that the regulators “reacted by saying, no water on the balance sheet” and banning such valuation for decades.