Is it an appropriate measure of value for today’s financial instruments?
The use of fair value accounting for measuring the value of financial instruments has been a source of controversy.
Highlights
1.The impact of fair value measurements—whether positive or negative on a
company—is the result of market forces.
2. Fair value of financial instruments, despite concerns, is the best available method to reflect market conditions.
Current conditions call into question
whether we are ready for fair value
accounting for certain non-financial items.
3. Investors benefit when companies
disclose their views on the impact of
market illiquidity in their financial reporting. |
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Financial statements reflect the impact of current market conditions on financial instruments.
Investors and other users have greater insight into management’s views as to ultimate settlement amounts.
Lack of market prices requires the use of models to determine
fair value.
Reported earnings are less predictable. |
The impact of fair value accounting
For many years, standard setters have grappled with the issues associated with accounting for financial instruments.
Decisions with regard to what valuation method should be applied have been difficult and in some cases controversial.
In 1994, FAS 115 was introduced into US GAAP as a partial solution. It required fair value accounting for many investments. In 2000, FAS 133 was introduced to improve the accounting model for derivatives by requiring fair value measurement. FAS 157, issued in 2007, established a common
definition of fair value. Then FAS 159 expanded the ability of companies to elect fair value as their measurement basis for certain financial assets and liabilities.
Some claim that only realized gains
and losses should be recorded.
Recently the US markets began experiencing significant illiquidity and volatility, creating conditions that made fair value assessments more controversial. The value of today’s innovative and complex financial instruments, such as derivatives, mortgage-backed securities and other structured financial products is subject to market illiquidity and volatility. Although fair value accounting could apply to other assets and liabilities, the focus of this piece is
on financial instruments (particularly
financial assets).
While many agree that fair value yields a more relevant measure than historical cost, it is not perfect. Two controversies surround fair value measurements today: (1) the application of fair value accounting in illiquid markets, and (2) how and when modeling should be used as the method to determine fair value.
Recent credit market conditions have resulted in large write-downs through the application of fair value measurements. Most of the charges have occurred within the banking and broker-dealer industries.
Companies providing credit protection
through credit default swaps on the
underlying asset, as opposed to insurance contracts, have been impacted by fair value measurements. Even though the default
that would trigger protection may not
have occurred, companies are required to
recognize unrealized losses on the contract when the fair value of the underlying assets has significantly decreased. Also affected have been some corporations with investments in auction rate securities which suffered declines.
The requirements to use fair value measurements have been criticized for producing inaccurate results in the unusual market conditions recently experienced. Such results, it is argued, hurt the company in the long run. If a company must record losses in such an environment, critics claim, it signals bad news to investors that may ultimately be misleading. Therefore, they say, it is preferable to record only realized gains and losses.
In considering this controversy, it is important to recognize that accounting principles such as fair value are developed with the objective of providing information that
will best serve the interests of investors,
businesses and policy makers over the
long term.
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Fair value, while not perfect, is the best method to reflect market conditions when accompanied by appropriate disclosure
We are sympathetic to the concerns about fair value measurements that have grown out of the recent market illiquidity and volatility. In response to these market conditions, it has been suggested that fair value accounting be suspended or changed for certain financial instruments, or that businesses should apply their own models, which may show a less volatile long-term scenario. The current market, it is contended, is an anomaly. However, these concerns must be balanced against investors’ desires to know the current values of these assets.
Balancing the factors, fair value still represents the most effective method to reflect the economic realities of market conditions. If fair value were suspended or replaced with some method based on historical cost, investors would be left to their own devices to determine the current value of these instruments—which would be less reliable and could delay any market recovery.
Fair value increases the transparency of the impact
of market forces on financial information.
Those contending that the current market is an anomaly may be correct. If they are right, the market will eventually recognize that, return to “normal,” and bid up the price of their holdings. However, in the interim, we encourage companies to present the basis of their views of the instrument’s value and ultimate settlement amount in their financial analysis disclosures.
Although investors in general believe that fair value is appropriate for measuring financial instruments, they and companies are concerned about the use of fair value when it is unclear how to determine market pricing. Fair value measures require (a) applying market prices regardless of how erratic the market may be, or (b) referring to prices of similar securities. When neither of those alternatives exists, companies employ models to determine fair value.
sometimes occurs when markets become illiquid and market prices are not available. When the methods described above for determining fair value are applied, the effect on earnings may be as unpredictable as the market. Like
a pendulum suddenly knocked out of its cycle, financial instruments may fluctuate as a result of market realities revealed in
fair value assessments.
is another concern. But whether any particular application of fair value measurements accurately reflects long-term value can only be decided in the long term. Fair value measurements enable financial statements to reveal how financial instruments are being affected by current market conditions, resulting in increased transparency to investors and others.
Although it has generated controversy, fair value continues to represent the best available methodology for determining and reporting the value of financial instruments. Markets naturally respond to financial information that fair value provides. The impacts of such measurements—whether positive or negative on a given company—are the results of market forces, not accounting methodologies. When market conditions result in volatility in values and earnings, investors benefit when companies transparently report on these circumstances and their impact on financial reporting.
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Investors, regulators, and the general public
are affected by fair value accounting
Q: Does the application of fair value accounting for financial assets present economic reality?
A: Fair value is the best available method
to measure and report financial assets.
Fair value is based on market measures
or, in limited cases, estimates of them. Some have contended that current market valuations of some complicated securities do not reflect eventual long-term reality—
for example, in cases where the market for these instruments has become illiquid. We understand that complex issues of valuation are open to reasonable arguments on both sides. So we encourage those whose views about ultimate settlement amount conflict with the application of fair value measurements to disclose their views within their financial analysis.
Q: What are the merits of using cost accounting versus fair value accounting for financial instruments?
A: Cost accounting would value financial instruments at their acquisition price—not at their value if sold in the market. Most investors prefer current valuation because it is more relevant. Historical cost information for financial assets has no economic relevance to the buy, sell, hold decisions management must make each day.
Q: Has the SEC taken any action in response to current market conditions regarding fair value accounting?
A: The SEC is concerned about the quality and consistency of the assumptions
and judgments inherent in fair value
measurements. Through a direct request
to a number of companies, the SEC is
looking for greater transparency in disclosures around related valuation methods
and assumptions, especially at major
financial institutions.
Q: What industries have been most impacted by the large write-downs that were required by fair value accounting?
A: Most have occurred in the banking
and broker-dealer industries and in some
Insurance companies. That reflects
their significant investments in debt
securities and derivatives, including
securitized interests.
Q: As more businesses use IFRS, will that mean a greater use of fair value
than we see in US GAAP?
A: For financial instruments, IFRS and US GAAP are generally consistent. However, for non-financial assets and liabilities IFRS generally encourages greater use of fair value than does US GAAP.
Q: Do you support expanding the use
of fair value measures to non-financial assets and liabilities?
A: We believe that recent events have pointed out the challenges that exist in using fair value accounting when markets are not sufficiently liquid to help establish fair values. For non-financial assets
and liabilities, those challenges may be
exacerbated. Current conditions call into question whether we are ready for fair
value accounting for certain non-financial assets and liabilities.
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