The running debate about the worth of fair value accounting is set to receive a further injection of energy over the next few weeks as banks puzzle over how to report the value of the derivatives and financial instruments that have been crippled by the credit crunch
Under fair value they should be valued via a ‘mark to market’ approach. In
short, they are worth what the market will pay now. But what if there is no
market activity? How do you decide the value? Here’s another way to put it. If
you put your house up for sale at £1m (London prices, of course) and it doesn’t
sell, can you really say it is worth £1m?
The debate raises further tricky and unanswered questions about what actually
defines the ‘market’. What the banks will do is anyone’s guess. One piece of
advice from the IASB is that the banks should take a write-down and then book
any bounce back when it comes.
But this difficult, and somewhat philosophical, accounting question helps
illustrate, not so much the problem with fair value, but with the decisions that
were made when these complex derivatives were created and more importantly when
they were bought.
Clearly the risks were not properly understood, there was poor understanding
of the fundamentals and perhaps no small amount of complacency. But can you
blame the accounting? The problem with fair value is that it makes the swings in
value look worse and the current crisis, especially at Northern Rock, is about
confidence. And when you think about markets, confidence can be said to be
everything.
The answer? Know what you are buying. Know the risks. And when it comes to
the accounting, communicate and communicate again. Accept no alternative.