Experts debate applicability of fair-value accounting

Fair-value accounting, commonly referred to as mark to market, should be suspended as such requirement is not assisting markets to return to normality, a top official from the Dubai Financial Services Authority (DFSA) has proposed. According to DFSA CEO Paul Koster, the fair-value application is highly pro-cyclical and has an accelerative effect in driving markets down further.

A moratorium in this regard will stop fair value feeding the vicious cycle without eliminating relevant information to the investor by means of its disclosure. He said this will allow time for the markets to return to normality and for international accounting standard-setting bodies to consider what needs to be done.

"I say fair-value accounting should be suspended but with an additional requirement of the disclosure of the valuation means," Koster told Emirates Business. "I am much more in favour of a narrative communication with investors today than give the investors the idea that there is a needle-point position in a valuation, which is actually in today's market is not really possible."

Koster said instead of using a needle-point precision of fair-value accounting, an improved disclosure paragraph in management's discussion and analysis on valuations can be more helpful.

"I suggest that they suspend the requirement of fair-value application for the time being," he said. "However, in the disclosure, management will detail what they did and the ranges of valuations that are available in the market – have they seen similar products, similar investments – and decide whether that is in a range, which they feel is appropriate so that the investor can decide whether he or she agrees with the chosen valuation."

Koster said the purpose of the proposed suspension is not to induce inconsistency or to create confusion in accounts, adding that the moratorium will not be allowed to continue beyond the point that is absolutely necessary, as it may lend itself to abuse from financial institutions when normalcy returns. The moratorium therefore needs to be lifted when the market is no longer distressed.

"I consider market is stressed when you have price movements in market that go way beyond what is a reasonable movement," he said. "Look at what happened to Barclays for example – in one day it was 70 per cent down and four days later it was 70 per cent up with the same kind of information – that to me is a distressed market."

"Would that be a precise moment to say that the market is no longer distressed? Everybody knows when the market is no longer distressed," he said.

In a paper he has recently authored, Koster said when financial markets are active, prices traded on them reflect consensus between buyers and sellers about the future cash flows of financial instruments, and on the degree of uncertainty surrounding them. Under these circumstances, fair value coincides with market prices.

"By marking to market in good times allows management to increase their risk taking and financial vulnerabilities tend to build up in the system. These are not properly costed," he said. "However, when markets drop, these financial vulnerabilities surface, which causes management to change its strategy and again fair value amplifies the cycle."

The paper argues that fair value brings about a downward spiral of values whenever the markets are illiquid or when actively traded markets are no longer rational. This is because mark to market takes into consideration market conditions at a specific time and therefore, the income statement is significantly affected by large fluctuations in the markets. Further, fair value appears to exacerbate pro-cyclical behaviour of financial markets.

Koster said he is not against fair-value accounting. He stressed it as "absolutely critical" but added: "What I am saying is that we have to make sure there is a market. Mark to market needs to have a market and no one ever thought the market would be like this."

In the current illiquid markets, he said, using fair-value accounting can severely affect banks in the following ways – capital is artificially eroded even in cases where solid fundamental credit performance is unchanged; the lending capability of a bank is reduced; and the accounting drives economic outcomes, including reduced availability of consumer and small business credit and a negative impact on the health of individual institutions while not reflecting economic reality.

Koster said, so far, the response to his proposal in general has been "quite positive". But he acknowledged that there are also many who have been against it.

"You have some who are obviously very much against it more so in Europe than in Far East," he said. "Europe would be very hesitant that is because the IASB (International Accounting Standards Board) had already been told to make an adjustment something that they are not too happy with. However, in the US, the FASB (Financial Accounting Standards Board) has relaxed some of the laws and allows companies to sort of suspend fair value accounting."

Indeed, a number of accountants and financial analysts negate the proposal.

Robert Garnett, Board Member at IASB and Chairman of the International Financial Reporting Interpretations Committee (IFRIC), said suspending fair value is not a solution to the problem. "The solution has to be finding what the alternative is and that is providing information that is current, relevant and identifies the extent to which an asset is subject to price changes because of various risks," he told Emirates Business.

"That's a better risk analysis and a better presentation of the volatility that is created within this assets."

Raj Madha, Director of equity research at Cairo-based EFG-Hermes, said: "In many ways, the global pressure to shift away from fair-value accounting has had a dramatically negative impact on both equity pricing and volatility. It has probably also resulted in many investors exiting the market, as the odds for successful investing are increasingly stacked in favour of traders plugged into the rumour mill."

"Fair-value accounting should not be replaced with anything but rather become more stringent for the companies," Dheeraj Lakhwani, Investment Analyst at Prime Emirates, said. "The point is that analysts and shareholders already know that fair-value accounting is non-cash flow. Mere showing higher profits will not solve the core business model as mentioned above."

"The companies will have to bear the consequences of the decisions which they took during the last two years – if they were conservative, they will report excellent results now. But if they were unaware of the boom, then vice versa… If for some reason, the accounting rules are suspended, which I personally think will happen, then it is an utmost shame for the accounting community," he said.

According to Koster, capital adequacy/solvency, consolidation and securitisation have occupied a higher place in discussions among global financial experts. But in many respects, fair-value accounting has been the cause of problems with capital adequacy, solvency and credit availability.

"What is happening right now is when you have to make an adjustment to the valuation of your asset, it runs through equity that means you have lower equity and we as regulators require solvency criteria therefore you need to have so much equity to be allowed to continue operating the balance sheet that you have," he said.

"And sometimes companies are forced to value assets that they have no idea and intention to sell in the near future at current prices. The market is not there."

But for Lakhwani, fair-value accounting is just one of the ingredients that affects the fundamental ratios. "It is not the key concept of running a business," he said. "Any business is sustainable on its operating cash flows and its core competencies. Look at India and China – has fair-value accounting drastically affected their ratios, No. Why? Because their business models were successful.

"The rule-makers or the ones who want to change the accounting rules must understand that they can change the rules to benefit these companies, in the short run. But then the companies which failed now or are on the verge of failing will never learn in the future and will be a burden on the tax payer for years to come. Rather, M&A and fair competition should be promoted to allow market forces to take charge," Lakhwani said.

Madha said: "If the problem is that of regulatory capital being hit more than regulators would like, the appropriate approach would be to relax regulatory constraints, either by changing the hurdle CAR, or by altering the calculation of regulatory capital, such as by excluding negative movements of the fair value reserve. That way the market could at least still make informed decisions."

Koster said unprecedented times call for unprecedented actions. He said: "Of course, suspending fair value will not prevent risk-taking financial institutions from failing. For example, the credit worthiness of an investment (ie mortgage-backed security) is still a result of the ability of the borrower to repay the loan as and when it falls due. However, as long as the borrower continues to pay, why should the MBS be marked down because the accounting standard demands it?"

Koster said in the short term, given the urgency of the situation, prudential regulators need to have the ability to seize the initiative, act swiftly and temporarily suspend/modify fair-value accounting.

Currently the DFSA is still urging other regulators to speak up.


'Changes unacceptable'

According to members of the Investors Working Group (IWG), the current political and special interest pressures placed on the Financial Accounting Standards Board (FASB) to change fair-value accounting standards are unacceptable and very troubling.

The IWG said they are concerned and dismayed by the lack of normal due process and the accelerated timeline for commenting on FASB's proposals on "other than temporary impairment" issues and determining whether a market is distressed.

In order to create high quality accounting standards, it is critical that the process be independent and free from political pressure. This will ensure that such standards are neutral and faithfully represent economic reality. To the extent that these new FASB proposals reduce the free flow of transparent and reliable financial information, they undermine investor interests and weaken their ability to make sound investment decisions.

Moreover, when this process is rushed and potentially compromised, it leads to an increase in capital costs, erosion of investor confidence, and ultimately a disruption of markets.

The IWG is an independent panel that will recommend ways to improve the regulation of the US financial markets. This diverse, non-partisan panel of experts is co-sponsored by the Council of Institutional Investors and the CFA Institute Centre for Financial Market Integrity. It expects to issue an initial report and recommendations this month.

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