Historical cost accounting is fading as India Inc marches into a new era. In the “fair value” accounting regime, what is a company’s really worth? This is the central question that accounting attempts to answer, and it is no easy exercise. Every answer invites debate, and that debate has now intensified, thanks to "fair value" accounting.
Under fair value, a company values its assets and liabilities based on what they would fetch today, rather than what they originally cost. The concept is not new — accounting has long operated under a "mixed model”, which records many items at historical cost while requiring that companies mark to market certain asset classes (such as securities and derivatives). But a host of factors have suddenly propelled the calculation of fair value from a secondary concern to a dominant theme of corporate accounting, and many companies are just beginning to understand the ramifications. If fair value takes full hold, as some have suggested it should, company results may look far different than they do today.
In stark contrast to most other accounting concepts, fair value has already achieved the improbable feat of making front-page news, thanks to its alleged role in the subprime mortgage crisis. Mired in mess, many financial services giants have staggering losses. The question has been: Has fair-value accounting played a role in the economic meltdown? The proponents of fair value say that the accounting standards merely help companies show how much their assets are truly worth at this very moment — and that the downfall of the financial institutions that took major write-downs after applying fair value was actually a delay in showing investors how much these banks were truly worth and were representative of a move toward a down market.
The ultimate intent of fair value is to give investors better visibility into how companies value their assets, and few deny that it achieves that aim. While recent events on Wall Street provide only an imperfect proxy for fair value's impact, those who claim that it will increase volatility have plenty of evidence on their side. The recent market conditions are most immediately felt by those fair valuing financial instruments. Fair value in accounting itself has come under attack from some quarters accused of making problems worse.
Yet not all criticism of fair value can be so easily dismissed. The credit crunch has raised three genuinely awkward questions. The first of these concerns which the bankers say that in a downturn fair-value accounting forces them all to recognize losses at the same time, impairing their capital and triggering fire sales of assets, which in turn drives prices and valuations down even more. Under traditional accounting, losses hit the books far more slowly. Some admire Spain's system, which requires banks to make extra provision for losses in good times, so that when loans turn sour their profits and thus capital fall by less.
The second — and immediate—question is how to value illiquid (sometimes unique) assets and how and when models should be used for its determination. A common solution is to use banks' own models. But some investors are concerned that this gives banks' managers too much discretion — and no wonder, because highly illiquid assets are worryingly large relative to many banks' shrunken market values. Such is the complexity of many such assets that it may not be possible to find a generally acceptable method. The best answer is to disclose enough to allow investors to form their own views. International Accounting Standards Board (IASB) has given a new guidance to the auditors and accountants on reviewing mark-to-market assumptions which should help in this regard.
The third problem is a longer-term one: the inconsistency of fair-value rules. Today the treatment of a financial asset is determined by the intention of the company. If it is to be traded actively, its market value must be used. If it is only "available for sale" it is marked to market on the balance sheet, but losses are not recognized in the income statement. If it is to be "held to maturity", or is a traditional loan, it can be carried at cost less impairment, if any. Different banks can hold the same asset at different values because of classification criteria prescribed by the standards.
Fair value is not perfect, but most agree it is relevant measure than historical cost for financial instruments. All companies would need to account for the effect of the recent economic turmoil on the business. If we are to have faith in accounting standards, fair value should be applied when the going is tough, as well as when it is fair. Long term confidence would be hurt by rejecting the fair value concept in response to short-term pressures.
Under fair value, a company values its assets and liabilities based on what they would fetch today, rather than what they originally cost. The concept is not new — accounting has long operated under a "mixed model”, which records many items at historical cost while requiring that companies mark to market certain asset classes (such as securities and derivatives). But a host of factors have suddenly propelled the calculation of fair value from a secondary concern to a dominant theme of corporate accounting, and many companies are just beginning to understand the ramifications. If fair value takes full hold, as some have suggested it should, company results may look far different than they do today.
In stark contrast to most other accounting concepts, fair value has already achieved the improbable feat of making front-page news, thanks to its alleged role in the subprime mortgage crisis. Mired in mess, many financial services giants have staggering losses. The question has been: Has fair-value accounting played a role in the economic meltdown? The proponents of fair value say that the accounting standards merely help companies show how much their assets are truly worth at this very moment — and that the downfall of the financial institutions that took major write-downs after applying fair value was actually a delay in showing investors how much these banks were truly worth and were representative of a move toward a down market.
The ultimate intent of fair value is to give investors better visibility into how companies value their assets, and few deny that it achieves that aim. While recent events on Wall Street provide only an imperfect proxy for fair value's impact, those who claim that it will increase volatility have plenty of evidence on their side. The recent market conditions are most immediately felt by those fair valuing financial instruments. Fair value in accounting itself has come under attack from some quarters accused of making problems worse.
Yet not all criticism of fair value can be so easily dismissed. The credit crunch has raised three genuinely awkward questions. The first of these concerns which the bankers say that in a downturn fair-value accounting forces them all to recognize losses at the same time, impairing their capital and triggering fire sales of assets, which in turn drives prices and valuations down even more. Under traditional accounting, losses hit the books far more slowly. Some admire Spain's system, which requires banks to make extra provision for losses in good times, so that when loans turn sour their profits and thus capital fall by less.
The second — and immediate—question is how to value illiquid (sometimes unique) assets and how and when models should be used for its determination. A common solution is to use banks' own models. But some investors are concerned that this gives banks' managers too much discretion — and no wonder, because highly illiquid assets are worryingly large relative to many banks' shrunken market values. Such is the complexity of many such assets that it may not be possible to find a generally acceptable method. The best answer is to disclose enough to allow investors to form their own views. International Accounting Standards Board (IASB) has given a new guidance to the auditors and accountants on reviewing mark-to-market assumptions which should help in this regard.
The third problem is a longer-term one: the inconsistency of fair-value rules. Today the treatment of a financial asset is determined by the intention of the company. If it is to be traded actively, its market value must be used. If it is only "available for sale" it is marked to market on the balance sheet, but losses are not recognized in the income statement. If it is to be "held to maturity", or is a traditional loan, it can be carried at cost less impairment, if any. Different banks can hold the same asset at different values because of classification criteria prescribed by the standards.
Fair value is not perfect, but most agree it is relevant measure than historical cost for financial instruments. All companies would need to account for the effect of the recent economic turmoil on the business. If we are to have faith in accounting standards, fair value should be applied when the going is tough, as well as when it is fair. Long term confidence would be hurt by rejecting the fair value concept in response to short-term pressures.
