Regardless of whether they like fair-value accounting or not, most of the players involved with the wholesale changeover to the new system begun this quarter agree that it will deliver shocks to the financial system. The likely outcome? Waves of volatility through the capital markets for the foreseeable future.
The knowledge of current market worth that fair value provides seems sure make investors more trigger-happy. What preparers and users of financial statements don’t agree on, however, is whether fair value is worth the cost of that volatility. The differing viewpoints were very much on display at two gatherings held last week to discuss the implications of the changeover to fair value under SFAS No. 157, Fair Value Measurements. The standard is effective for fiscal years starting after Nov. 15, 2007 and for periods within those years.
For sophisticated investors—the managers of large pools of capital—there’s no question that fair value is worth more than its own weight in volatility. Putting down accurate bets on swings in the market is how they make their money, so more volatility means more opportunity. On top of that, mark-to-market accounting offers hedge fund, private-equity, and portfolio managers another tool for learning how to handle the assets under their management. To top it off, fair value, by rendering the financials they analyze more transparent, could help them cut down on their costs and workloads.
But big investors also claim that fair-value serves a greater economic good. The shakeup it’s likely to produce will prove a helpful corrective to the lax practices that developed during the real estate bubble and that helped spawn the subprime crisis, they say. “Volatility is good,” R. Harold Schroeder, director of relative-value arbitrage at Carlson Capital, said during a gathering for the media on fair value sponsored on Thursday by the CFA Institute Centre for Financial Market Integrity. “When you have too little, people don’t question things as much.”
While in the near term fair value is likely to spawn economic bumpiness, over the long haul it will help build “a healthier base for the economy at large because companies would assume less risk” than they’ve done during the subprime bubble, Adam Hurwich, a managing member of Calcine Management LLC, a private partnership, said at the CFA meeting. Advocates say mark-to-market accounting will supply a clearer view of the assets currently backing the risks that companies take than historical cost accounting has.
The bumpiness, however, could spur a surge in lawsuits against corporations brought by classes of retail investors angry about downward swings in their share prices. “Increased volatility—the byproduct of fair value—will lead toward more litigation,” said Antonio Yanez, Jr., a securities lawyer with Wilkie, Farr, and Gallagher, at a conference on fair value held by the Directors Roundtable in New York the day after the CFA meeting.
The uptick in accounting-related lawsuits will starkly contrast with the downward trend over the last few years, he said. While some say that downturn trend stemmed from the positive effects of the Sarbanes-Oxley Act and others attribute it to improvements in accounting, “everyone agrees that the relative absence of volatility in stock prices” is the major cause, Yanez said.
In the wake of the subprime crisis in particular, plaintiffs are likely to use fair-value standards to charge companies with writing down assets too late, failing to disclose certain practices, failing to provide warnings of a possible drop in share prices, and other shortcomings, according to the lawyer. Further, he said, “risk management practices and disclosures about risk management practices are going to be the subject of increased disclosure.”
The judgment of corporate finance executives and company auditors about how to apply the fair-value hierarchy set up by SFAS 157, will be another target of litigation, he predicted. The hierarchy breaks down valuations into three levels based on the relative amounts of market information available: In level 1, an asset or liability can be valued based on a quoted price in an active market; in Level 2, it can be valued based on information other than quoted prices but with “observable market data”; and in Level 3, it can be valued only through “unobservable inputs” and the best available information under the circumstances.
The hierarchy sets up a situation in which issuers and auditors will sometimes be required to make difficult judgments about which levels to slot certain assets and liabilities into. “The judgments can be second-guessed, and they will be second-guessed aggressively,” Yanez said.
But the second-guessers might not always succeed. “In saying litigation is going to increase, I’m not going to say defendants are going to lose more,” the attorney added. But whatever the outcomes of the cases, they will still have to pay for the work of Yanez and his peers.