Fair value: standard scapegoat

Critical: Ken Lever

As mortgage rates climb, banks cut back on their lending, once mighty Wall Street institutions collapse before our eyes and the world’s major economies head for a nosedive, many are starting to ask: are accounting methods partly to blame for the credit crunch causing havoc across the globe?

Academics, legislators and banks are all pointing the finger in the same direction, saying that fair value accounting may be creating unnecessary volatility in banks’ accounting: what’s more, some suggest that in driving asset values down, it may now be driving us ‘into the abyss’.

Accounting methods only rarely get this much attention, and the criticisms are fairly simply expressed.

‘Currently the so-called market prices of sub-prime debt are low due to the fact that there is no one willing to buy ­ in reality much of this debt will never default. The prices imply a level of default that is unrealistic. It would be much better to apply an impairment test to assets rather than mark to a market that is adversely affected by sentiment, volatility and uncertainty,’ Ken Lever of the Hundred Group of Finance Directors says.

‘For example the market said Northern Rock was worth 90p before it was “nationalised”, now the government say it is worth nothing. Which is the “fair” value?’ he adds.

Company fears are shared by investors. Royal London Asset Management has questioned whether using fair value at all times ‘is necessarily helpful to the health of financial markets’.

Stella Fearnley, professor of accounting at Bournemouth University, says that academics have long questioned the benefits of fair value, only now being examined because of the downturn.

‘In the US the investment banks adopted the use of fair value standards early in 2007 because it bumped up their profits. Now they’re saying it’s not right… because it is potentially creating more volatility in a stressed market, particularly in the banking sector.
‘I’m not sure this volatility helps this sector, which requires an element of stability. Yet on a quarterly basis, because so much of banking business is being fair-valued, you get an awful mess in that there are swings from one quarter to another… with people not knowing whether these figures are right or wrong,’ she says.

The problem, at the moment, is a lack of clear alternatives. Several advisers to the European Commission have suggested ‘smoothing’ values over a twelve month or six month period to avoid day-to-day fluctuations.

But not all agree: ‘I think it’s a worse answer,’ says Ken Wild of Deloitte.

For the banks it may be fine, he says, but what about a pharmaceutical company which has just had a drug withdrawn from the market due to concerns about side-effects. Would an average value for the company be better than one that reflected the latest ­ genuine ­ drop in its real economic value?

Wild says the market can make its own mind up over whether fair value accounting reflects real values, and if it doesn’t, bid prices up or down.

But in the febrile atmosphere of bank valuations at present, some will wonder whether trusting to the market is a safe way to steer global economies to safer waters.