Fair value: a fair cop?

September could be an awkward month for US banks. It’s reporting season, and
the expectation is that the sub-prime loan losses that have been hitting the
stock markets for the last two months are now, in the latest round of quarterly
figures, set to hit the books.

And as the banks mark down the value of the complicated instruments forged
out of the loans they are based on, there are questions being asked, not just
about the lending decisions, but also the way they are accounted for.

Academics contend that fair value accounting, has created a self-inflating
bubble of over-valuation in markets, and fails to restrict directors in
overstating the true position of their companies.

‘Fair value has taken the conservatism out of accounting and made numbers
less reliable. Instead of curbing business excess fair value accounting has fed
the bubble,’ said Stella Fearnley, who will shortly take up a chair as professor
of accounting at Bournemouth University.

Previously, such derivatives would have been valued at historical cost or
market value, whichever was lower. Fearnley argues that this more conservative
accounting might have helped prevent the US woes.

‘As far as I can see the fair value model is down the toilet. We need to step
back from this and reintroduce conservatism into accounts,’ Fearnley added. If
instruments owned by banks carry an inflated ‘fair’ value, that will cause the
banks’ shares to be marked up, creating a dangerous cycle, she argues.

Not all agree with Fearnley’s analysis. One standards-setter went so far as
to describe the view as ‘idiotic’ and ‘blaming the messenger’.

Senior figures concede, however, that fair value does bring a measure of
volatility to accounting. BP was a good example earlier this year, when it wiped
out $400m (£198m) of oil derivatives contracts one quarter, which it had booked
only three months earlier.

Defenders also argue that without fair value, the derivatives at issue in the
US would not even have been in the accounts to begin with.

And equally, as far as the investment funds that took on some of these
contracts are concerned, they have always used fair value and always will, since
they have to value the fund at market prices to allow investors to get in and
out.

Big Four experts say that fair value may not be perfect, but it is far better
than the alternatives, for now at least. The IASB maintains that its association
with fair value is overplayed. Whether that’s true or not, the future of the
accounting method looks like being one of its biggest challenges.