Fair Value: Lousy, But What’s the Alternative?

IASB's Thomas Jones sounds off about fair value for financial instruments, and defends the idea of mark-to-market accounting.

Fair value accounting may be imperfect, but it is better than the alternatives, according to Thomas Jones, vice chairman of the International Accounting Standards Board.

At an industry meeting last week, Jones naturally sided with investors and accountants rather than bankers on the question of whether fair value exacerbated the current credit crisis. But he cannot be accused of hiding behind rose-colored glasses.

“It is a lousy system, but it is less lousy than any other system … and I don’t find that the people who criticize fair value have very good ideas for an alternative,” asserted Jones, who was speaking at a financial reporting conference sponsored by the New York Society of Security Analysts. The alternatives include traditional historic cost accounting, averaging the values, basing values on contractual amounts, and what Jones described as “what you wished it was” or “what it ought to be.”

Bankers have been vocal of late in urging standard setters, regulators, and Congress to suspend or eliminate the mark-to-market methodology. In fact, the American Bankers Association, among other critics, blamed fair value accounting for aggravating the credit crisis by forcing lenders to slash the value of mortgages and mortgage-backed securities when the bottom fell out of the housing market. The decrease in asset values on bank balance sheets led to weaker regulatory capital ratios. Without the proper regulatory cash cushion, banks are prohibited from lending to each other or to corporations and consumers, resulting in a stagnant credit market.

Jones agreed that it is legitimate for the ABA and others to question whether the current downward spiral in the values of mortgage-related securities is “an infection which is self-reinforcing.” However, he said he doesn’t expect standard setters to answer the question by moving away from fair value. “I don’t hear too many sane people saying scrap fair value and go back to historical cost,” he quipped.

Jones also told the audience that two other accounting issues are adding fuel to the credit crisis fire: consolidation and derecognition of off-balance-sheet assets and liabilities, and related disclosure requirements. Regarding the former, Jones mused: “It’s pretty obvious that when banks take billions of dollars off the books so it disappears from sight, and then 18 months later it is back, you’ve got to question whether [the accounting] should have been different.”

While the accounting of the assets was not wrong, he noted, he thinks some banks may have been “a little careless” not to keep tabs on corporate balance sheets that claimed to be transferring assets, only to see them boomerang back when the economy sputtered. Jones, a former chief accounting officer and principal financial officer for Citicorp, also pulled an example from the news, the U.K.-based bank Northern Rock, to reiterate his point about disclosure requirements. He argued that current disclosure requirements are adequate, but that investors, as well as financial statement preparers and users, ignored the writing on the wall.

Northern Rock had to be bailed out by the British government last year after the credit crisis hobbled the lender. According to Jones, Northern Rock’s financial reporting was “superb.” He said the bank adopted early the IASB off-balance-sheet disclosure policy, known as IFRS 7, “which I though was a good standard.” However, “in hindsight, we could have used a little more disclosure of the liability side.”

Nevertheless, Jones insisted that by looking at Northern Rock’s IFRS 7 report, an investor can “instantly see” that about 18 percent of the bank’s business involved borrowing for 90 days or so, and lending for 30 years. “So you know that the first time there was any crisis [the bank] would hit the wall” he said. He added that he saw the Northern Rock situation as less of a disclosure deficiency than a “suspension of disbelief.”

Northern Rock officials could not be immediately reached for comment.

Jones also went on record as saying that in general, he and other IASB members support fair value accounting for financial instruments, but “don’t believe in fair value for the factory or production machinery.” Jones observed that leaving aside the issue of mark-to-market accounting in an illiquid market, “I think fair value does capture reality.” The only thing historical cost captures regarding financial instruments is an “accurate” but “meaningless” number, he opined.

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