Crying Foul Over Fair Value? Don’t. (Commentary by Rachel Kremer)

Why are some members of Congress blaming the country’s current economic woes on something as boring as a relatively new accounting pronouncement?

Why are CFOs across the country and the American Bankers Association, among others, blaming “fair value” accounting for aggravating the financial crisis? It would be easy to assume there must be something wrong with fair value or “mark-to-market” accounting, but let’s review the facts before jumping to conclusions.

In the past, what guidance existed in accounting rules for fair value measurements was spread among many pronouncements. In an effort to address the differing definitions of fair value and provide guidance for the application of these definitions throughout all of the generally accepted accounting principles, the Financial Accounting Standards Board issued statement number 157, “Fair Value Measurements” in September 2006. It became effective for public companies during quarterly reporting in 2008.

The goal of SFAS 157 was to create a single definition of fair value along with a framework for measuring fair value. The Financial Accounting Standards Board hoped to create additional consistency and comparability in fair value measurements and to expand disclosures about fair value measurements for the users of the financial statements. Did they miss the mark? Or did they — by requiring additional, more robust disclosures — tip over that first domino? Or does it really matter at all?

Fair value accounting is also known as “mark-to-market” accounting. This means that financial assets and liabilities are recorded and disclosed at market prices as of the date of the balance sheet. Basically the value is what a company could sell these assets and transfer these liabilities for today, and not valued at what they originally cost. The goal was to increase transparency by reflecting the current value of the assets and liabilities in determining a company’s financial position and not the historical cost value. And, to most it would seem logical that a company’s balance sheet should reflect the current intrinsic value of assets and liabilities and not a historical number that may be nowhere near its value today. Further clarification from the FASB issued this fall provides guidance on re-pricing assets in an inactive market.

The American Bankers Association has blamed fair value accounting for aggravating the financial crisis by making lenders cut the value of mortgages and mortgage-backed securities when the housing market experienced such significant declines in underlying value.

The decrease in these types of assets on financial institutions balance sheets led to weaker or deficient regulatory capital ratios. Below the cash regulatory position, banks were prohibited from lending to each other or to companies and consumers, contributing to the stagnant credit market. Banks also claim that the new standards compelled them to dump securities at fire sale or liquidation prices.

However, larger investors would argue that fair value accounting merely reflected an economic volatility that was there already.

In the latest staff position on SFAS 157, FSP 157-3 provides guidance on valuing financial instruments in a market that is illiquid or not active, reinforcing the notion that “the fair value measurement objective remains the same, that is, the price that would be received by the holder of the financial asset in an orderly transaction (an exit price notion) that is not a forced liquidation or distressed sale at the measurement date.” The thought here is that the market place should be orderly, not dysfunctional, and that any valuing of such instruments can take this into consideration through other valuation methods. However many groups including the ABA are not convinced.

In a letter to Christopher Cox, SEC Chairman, from Edward L. Yingling, president and chief executive officer of the ABA, Yingling writes, “Given the importance of this issue, the impact it has on the crisis in the financial markets, and the seeming inability of the FASB to address in a meaningful way the problems of using fair-value in dysfunctional markets, we believe it is necessary for the SEC to use its statutory authority to step in and override the guidance issued by FASB.”

But blaming the credit crisis on fair-value accounting is much akin to blaming the doctor for your medical diagnosis. Doctors – like accountants – are trained to identify existing conditions. And just like patients, you should have all the facts and latest information to be able to make informed decisions.

That’s fair isn’t it?

(Rachel Kremer, CPA, is a Moore Stephens Frost Audit Member with more than 20 years of accounting experience. She is Accredited in Business Valuations. She can be reached at [email protected].)