Fair values in financial reporting

¶ … Value Accounting

The Effects of Fair Value Accounting on Financial Statement Reliability and Considerations in the Current Credit Crisis

Regulatory legislation defining and mandating fair accounting practices in all publicly traded companies and most financial institutions was developed in the wake of the Enron scandal and took full effect in 200&, less than a year before the onset of the credit crisis and the general economic collapse that led to the current (or recently ended, depending on who you ask) recession (AICPA 2009; Moyer 2008). Many analysts blame the downturn in part on the accounting methods required by the fair value accounting standards and the enormous write-off that major banks suffered in the lead up to and during the credit crisis. Specifically, claims have been made that fair value accounting leads to a pessimistically low and unreasonably low valuation that does not take exiting capital and management skills into consideration, thus letting fear rule over objectivity (Moyer 2008).

The two issues of financial statement and valuation estimate reliability when fair value methods are used and the role that fair value accounting methods played in the development of the credit crisis are quite interconnected, with the former being an alleged primary cause of the latter. This argument can be understood in two ways: first and foremost, it is contended that fair value accounting practices lead to undervaluation and in the current crisis the paper loss of increasing amounts of wealth, which eroded confidence and thus dried up credit markets, which becomes a self-exacerbating problem (Moyer 2007). On the other hand, it could also be claimed that fair value accounting methods simply aren't effective at determining real value in a useful way any more so than other practices.

This second options is perhaps the more plausible of the two, as there was certainly some indication in the current credit crisis that estimates -- even good-faith estimates -- of the value of certain securities, other assets, and entire institutions were grossly misrepresentative (AICAP 2009). There is also little doubt that the fair value accounting methods have led to an increase in market volatility, although more time is needed to determine whether this is a temporary circumstance based on the novelty of the accounting methods prior to the downturn, or if the observed trend of increased market volatility will be a long-term effect of fair value accounting methods (AICAP 2009; Moyer 2008).

This latter state of affairs seems likely, as the use of fair value accounting practices means that values must be continually adjusted based on existing market fluctuations (AICAP 2009). As changes in value necessarily have an effect on the market, it only stands to reason that the more frequently and drastically values are adjusted, the more the market will fluctuate in response. In theory, of course, this means that values would end up fluctuating more in response to market fluctuations, which would lead to further market fluctuations and thus more value changes, etc., etc. etc. In reality it is doubtful that this state of affairs would lest into perpetuity, as eventually investors would become used to the new schema and reactions would grow more measured. And even the initial volatility that has been observed might not indicate a problem.

Moyer (2008) claims that in discounting existing capital and management, fair value accounting practices replace objectivity in financial analysis with fear. What this claim in essence boils down to us that fair value accounting practices demand values to be assessed solely on the current state of affairs rather than on potentials. Clearly, management and capital are only as valuable as what they are able to produce; an assessment of value based on their capabilities necessarily calls for a prediction, which will necessarily be subjective. The "fear" that Moyer refers to is an uncertainty regarding the future, and though stock analysts have consulted with psychics in the past few have claimed outright to have certain knowledge of the future. Current fair market value is truly the only objective measure of an asset's or company's worth, and though it might not be fully accurate for failing to take into account the potential for growth it must still be considered more accurate than accounting methods that depend on vague possibilities or blithe and naive assertions of expectations and desires, however fearlessly they may be made.