Could a different accounting method have stopped the shocking collapses of investment banks, Lehman Brothers and Bear Stearns? Looking ahead, Christopher Adam, a professor of finance at the Australian School of Business, raises a pressing question: How much volatility can we live with?
Accounting standards are rarely seen as a hot bed of passion and debate. However, heated conjecture in the aftermath of the global financial crisis over whether fair-value accounting practices exacerbated the meltdown and heightened market volatility has gripped the profession. Politicians, economists, business leaders and professional associations have traded opinions in a discourse that seems set to have long-term implications for auditors, financial controllers and company directors as they go about their respective corporate duties. As the dust settles, it’s timely to consider the nature of fair-value accounting versus historical-cost practices.
Fair Value vs Historical Cost?
Fair-value accounting – often referred to as mark-to-market accounting – in essence, involves using available market information to estimate the likely sale price of an asset or the cost to settle a liability. While the principle dates back about three decades, it has come to the fore over the past 15 years in an era of greater market transparency. The theory goes that applying current market information to valuing assets and liabilities is the best way to give investors up-to-date information about the economic status of companies.
By contrast, historical-cost accounting is a traditional method whereby assets are valued at their original cost and exclude adjustments for inflation. These historical cost or book values do, however, factor in adjustments such as depreciation and impairment.
Both standards are in wide use and have their proponents and opponents. Supporters of fair-value argue it delivers more timely and relevant market information despite the increased use of estimates and judgments, while detractors claim it provides unreliable market information that can give investors the jitters. Fans of historical-cost believe it is more dependable because asset values are based on actual transactions, but critics contend that acquisition values under this method are often years old and may offer little relevance to investors.
In the search for culprits after the financial crisis, some political and industry commentators have pointed the finger of blame at fair-value accounting. A recurring allegation in some quarters is that it contributes to excessive leverage in boom markets and similarly overblown write-downs of assets during a bust. One scenario which critics advance is that banks are forced to sell distressed securities at fire-sale prices, depleting bank capital and sending asset values through the floor. This can lead to a downward spiral that hurts banks and investors.
While large losses can clearly cause problems for banks and other institutions, the jury is out as to whether reporting these losses under fair-value accounting creates additional problems. Would the market have reacted differently if banks had used a different set of accounting standards?
John Kidd, a partner in the assurance and advisory team at consultancy firm Deloitte, says while accounting principles were not the original cause of the crisis, there is an argument to suggest they “sped up the impact”. “But only because accounting standards are definitely more fair-value based these days than historically was the case. So they are by definition going to reflect more current information,” he says. However, Kidd stresses the point that the switch to fair-value accounting is far from complete, with trading-type operations tending to report under those standards while banks assess most of their assets and liabilities under historical-cost principles. “You don’t want to overstate the case that we have gone to full fair-value,” he says. “It’s probably the companies that were at fair-value that were at the more aggressive end of markets in the first instance.”
Chris Adam, a professor of finance at the Australian School of Business, is an advocate of fair-value accounting but comments that the approach is “inevitably forward-looking”. “You have to learn to live with more volatility,” he says. What level of volatility is acceptable, however? Adam asks: “Is there something like a fixed figure or do we simply get comfortable with larger value movements and don’t reason that 20% is worse than 10%?”
He notes that a classic accounting response to volatility is to recommend hedging. While that can reduce overall volatility, it comes at a price. “It’s really a case of how much volatility we can live with. We could take the view that ‘well, we’ve not lived with a lot of change in the past’ and where we’ve thought there might be a lot of volatility we’ve done things to offset it and taken out hedging, which takes you back to the point of saying ‘we are not comfortable with this degree of volatility’. Then it may be sensible to go with data that move more lethargically – as with historical-cost, for example.”
One of the prime areas of analysis following the financial crisis has been the big banks’ treatment of collateralised debt obligations, or CDOs, a financial structure that groups loans, bonds or assets into a portfolio that can be traded. The value of many CDOs plummeted during the financial crisis on the back of the sub-prime mortgage debacle in the US where the banks gave high-risk loans to people with poor credit histories.
Adam says the fallout from the crisis supports the case for banks being more flexible and less mechanical in their approach to loan repayments. “What exacerbated the financial crisis was the speed and size of the fall in values to which banks applied credit rules, forcing liquidation of assets in a hurry,” he says. “This had the overall effect of pushing the prices down further.”
Adam feels Western bankers could learn a lesson from their Japanese counterparts, who have long operated in a banking culture that applies historical-cost accounting practices. “Japanese banks were more accommodating to their borrowers when collateral values declined,” he says, “This behaviour may have helped borrowers ride out the storm a little more.” However, the Japanese market has a flip side. Since the 1990s, its banks and economy have struggled, with some blaming its reliance on historical-cost accounting. “A culture perhaps less permissive than the Japanese structure, but a little more permissive than we saw in the Anglo-Saxon system, may be advisable, at least in the short run,” Adam suggests.
Some critics of fair-value accounting have argued that the shock collapse of venerable investment banks Lehman Brothers and Bear Sterns may have been avoided under a different accounting regime. Baljit Sidhu, editor-in-chief of the Australian Journal of Management and a professor of accounting at the Australian School of Business, doubts it. “The primary problem with companies like Lehman Brothers was a failure in risk management and liquidity. They took on too much risk and, when the market woke up to it, they had a crisis,” she says.
While historical-cost accounting may have delayed the delivery of some market information on distressed companies, Sidhu notes that there are myriad sources of information. “In essence, investors, creditors and regulators use accounting signals to form opinions and make decisions … If there is other information in the market you might actually have heightened uncertainty because the accounting is not catching up. So it’s not clear that having historical-cost accounting would have calmed everybody’s nerves. People are not stupid. They understand (when a) value is an old value.”
Ultimately, accounting attempts to reflect the underlying economic circumstances, albeit not always with precision due to measurement issues. “The accounting is actually the barometer of declining or improving circumstances, not the cause of it,” Sidhu says.
Graham Mott, a partner and auditor in the financial services division at Deloitte, supports the increasing shift towards fair-value accounting, but concedes the accounting profession will face tests under any system. “Typically cost accounting leaves us in a worse place in terms of transparency and the validity of the information it provides users,” he says. “The challenge then becomes how do you fair-value account where you have very limited market activity or in some cases no market activity. The accounting is designed to provide the best estimate of fair-value when you have that limited information … It doesn’t mean that it’s exact or necessarily right. It just means it’s the best estimate available.”
Mott endorses the adage that “disclosure is your friend” when there is a broad range of potentially acceptable market prices for an asset. “The ability to disclose that range of possible outcomes is often your friend in that situation,” he says. “That’s where disclosure needs to fill the gap if you have limited market information.”
Accounting standards will continue to evolve and improve, especially as a consequence of the financial crisis, according to Mott. “The times we have been through have been unprecedented. The volatility in the market has been unprecedented. Therefore, fair-value accounting has had to respond to those times in the best way that it can. While there are (companies) out there that, perhaps, don’t like the value they’ve had to mark their assets to, it’s been a reflection of where the market has been.”
Adam acknowledges that some refinement of fair-value practices could be advantageous. The process through which the value of assets is actually measured is one area open to review. While Adam favours indicators such as the present value of assets and discounted cash flows, others in the accounting fraternity focus on ratios and the price of comparable assets, for example. “There’s more of a discussion [required] about what we mean from the technical end of measuring fair value,” Adam says. He also backs the call for greater financial literacy to help all players in the market. Inexperienced investors, for example, often panic when asset values are waning and seek to close out those investments. “[It’s about] giving people a greater sense of comfort that fluctuations in value are not a surprise – that they are actually telling you some information,” Adam says.
The Bottom Line
It is clear the global financial crisis has been a wake-up call for global markets, and inevitably the dramatic event will lead to some overdue changes. Deloitte’s Kidd notes the International Accounting Standards Board, a London-based accounting standard-setter, has already moved to establish a common principle for offsetting financial assets and liabilities that provides more useful information on an entity’s future net cash flows. Hedge accounting rules have been simplified to ensure closer alignment between accounting and company risk management strategies, while changes to the impairment of financial assets are also pending.
“The accounting standards have reflected where accounting can be improved and they’ve made those changes,” Kidd says. He adds that there will always be debate over the correct market value of assets under fair-value practices. “To the extent that markets are distorted, the values are going to be extorted and that, unfortunately, is reality.”
Kidd warns against pressure for accountants, rather than the markets, to arrive at more realistic values for assets and liabilities, saying such a move would effectively call on practitioners to “outguess the market”. “That’s a level of judgment that accountants really aren’t capable of making,” he argues.
Any regulatory changes notwithstanding, the consensus among most commentators appears to be that fair-value accounting did not prompt the bank failures of 2008. A report by the Securities and Exchange Commission in the US comments: “Fair value and mark-to-market accounting do not appear to be the ‘cause’ of bank and other financial institution failures. Rather than a crisis precipitated by fair-value accounting, the crisis was a ‘run on the bank’ at certain institutions, manifesting itself in counterparties reducing or eliminating the various credit and other risk exposures they had to each firm.”
In a widely read article in the Journal of Economic Perspectives last year, respected finance academics Christian Laux and Christian Leuz also came to the conclusion that suggestions fair-value accounting exacerbated the credit crunch are “largely unfounded”. “Based on our analysis and the evidence in the literature, we have little reason to believe that fair-value accounting contributed to American banks’ problems in the financial crisis in a major way,” the authors say. “Fair values play only a limited role for banks’ income statements and regulatory capital ratios, except for a few banks with large trading positions. For these banks, investors would have worried about exposures to subprime mortgages and made their own judgments even in the absence of fair-value disclosures.”
Laux and Leuz add that banks have safeguards and discretionary powers that enable them to get around any distortions in market prices. At the same time, they are not advocates for the further extension of fair-value accounting and say the practice clearly is not perfect: “We need more research to understand the effects of fair-value accounting in booms and busts to guide efforts to reform the rules.”
At the Australian School of Business, Adam agrees, adding that in his “heart of hearts as an economist” he is a believer in fair-value accounting. He does offer some caveats. “It must capture the appropriate level of risk, and institutions must learn to deal with greater volatility and more acceptance of it. I’d rather live with more fair-value than less, but it’s contextual.”
Deloitte’s Kidd reaffirms his underlying faith in market forces. “The great thing about the capitalist society is that while many would say that governments saved financial markets by bailing them out, the impact of the financial crisis has been to cause companies and financial institutions to dramatically reassess where they were found with holes in their risk management systems. It has been incredibly good medicine for those companies.”