Fair value: unrealistic?

On Wednesday, the US Securities and Exchange Commission holds an open discussion on the value of fair value accounting and auditing standards.

The move from historical cost accounting to fair value, or mark-to-market as it is also known, has been a major project by the major accounting standards boards, the US Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). The effort was seen as an improvement on information disclosure by providing investors with a better representation of economic reality.

Yet during the heightened uncertainty of this past year’s credit crisis -- which stemmed from the increased opaqueness of financial products and significant market volatility -- fair value accounting produced billions of unnecessary bank write-downs, argued the IMF and banking groups in reports released last April. The rule obliges banks to use market values for assets instead of internal models, which can be manipulated.  Yet problems arise when there is no trading floor or market for assets. In such cases, assets are marked down to zero.

Like other sophisticated financial models, fair value relies heavily on the existence of efficient markets to work properly. In theory, markets are efficient when prices reflect all available information, thus fair value is assumed to help lead to efficient markets. Nevertheless, the booms, busts and irrational exuberance of recent years -- added to market information that is highly asymmetric and opaque -- suggest that markets have been anything but efficient.

In this respect, fair value accounting may not be the solution in the search for better financial disclosure. If its practice led to knee-jerk write-downs, even when banks could have held the assets to maturity at which point the value could be positive, it suggests that accountants overstated the problems at the largest US banks, with grave effects on the financial system.