Point-Counterpoint on Fair-Value Accounting (CFA ...

M AG A Z I N E

July/August 2008

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Point

Counterpoint

The use of fair value for valuation and accounting improves financial reporting and enhances market transparency. AGREE

Fair Value Rules Shed Light on Economic Realities BY AHMED SULE, CFA

A

number of financial institutions continue to suffer significant losses as a result of writing down the value of their mortgage-related assets. By the end of April 2008, total estimated credit losses and write-downs arising from the subprime crisis were estimated to be around US$312 million. These losses are expected to accelerate in other areas of the credit market—such as auto loans, leveraged loans, credit cards, and commercial real estate markets—as conditions continue to deteriorate. The latest Global Financial Stability Report from the International Monetary Fund estimates that the potential global losses resulting from the credit crunch could total US$945 billion, which suggests that more write-downs are likely. As losses have mounted, various policies, individuals, institutions, and regulatory regimes have come under scrutiny, and in the last couple of months, fair value accounting rules in particular have been put in the spotlight. Some commentators argue that the application of these rules exacerbated the crisis; others suggest that the rules actually caused the credit crisis. Are the critics right, and if so, what should be done? Modest Proposals

Among the detractors are key players in the financial sector—including Wall Street, the City of London, regulators, and various market observers. Just as firms have begun reporting under Financial Accounting Standard (FAS) No. 157, Fair Value Measurement, for the first time, the cynicism toward fair value rules has intensified, partly as a result of the disclosure requirements for “Level 3” assets (that is, financial assets whose reported value is based on unobservable inputs that reflect management assumptions). Opponents of the rule argue that companies should not be required to write down the value of their assets when the market is experiencing illiquidity brought about by investors retreating from mortgage-backed securities tainted by subprime loans. In this view, fair value measurement forces companies to value illiquid assets at distressed prices that do not reflect “real” value. Furthermore, in the current environment, observable prices used to mark down these assets should be disregarded because the volume of transactions traded by investors is lower than the “normal” transaction volumes that typified the period prior to the credit crunch. According to this logic, because these institutions intend

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to hold these mortgage-related assets for the long term, forcing the institutions to mark the holdings to market at the current deflated prices is unfair. Moreover, some observers point out, the current prices for subprime debts that are being used for marking to market suggest an unrealistic level of default. The consequence is a self-reinforcing process: Writedowns lead to forced sales (because of capital depletion), and forced sales result in depressed prices and further write-downs. Some critics have even argued that under fair value rules, companies that hold illiquid financial instruments are forced to value their holdings on the basis of newly created indices, such as ABX indices, that reflect a downward bias driven by investor fears, thereby increasing the level of write-downs. [Editor’s note: For further discussion of ABX indices, see the Trading Tactics article on p. 16 in this issue.] What can be done about the pernicious effects of fair value accounting? Detractors have not been shy in offering suggestions, which fall into three categories. The first suggestion is for companies to move away from fair value accounting. Cynics in this camp include Martin Sullivan, former CEO of AIG in New York City, who suggested in an interview with the Financial Times that companies should estimate the maximum losses they expected to incur over time and recognize only those losses on their income statement. They should record the remaining unrealized losses on the balance sheet rather than the income statement. The second suggestion is for the mark-to-market rules to be suspended until the end of the credit crunch. In a recently published report, the Institute of International Finance advocated the implementation of “circuit breakers” for fair value rules to limit the incidence and levels of write-downs and forced liquidations. The third suggestion involves relaxing the rules to lessen the severity of losses and write-downs. For example, the European Financial Reporting Advisory Group recommends using average observable prices rather than period-end prices as a reference price for write-downs. Unwarranted Criticism

Is fair value accounting really to blame for causing or exacerbating the credit crisis, and if so, should the rules be suspended, relaxed, or canceled? Admittedly, fair value measurement is not a perfect system. Its application can be complex and subjective, especially with regard to the use of mark-to-market models in illiquid markets for which observable prices are not available. But calls to scrap or suspend the implementation of fair Continued on page 54

M A G A Z I N E / J U LY- A U G 2 0 0 8

Copyright 2008, CFA Institute. Reproduced and republished from CFA Magazine with permission from CFA Institute. All rights reserved.


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DISAGREE

Fair Value’s True Believers Are Wearing Blinders BY WARREN D. MILLER, CFA

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n a recent phone conversation with an accounting professional who’s a strong proponent of fair value, I asked if she thought that a balance sheet should reflect market cap as of the balance sheet date. She said it should. I asked her how to recognize “the residual,” goodwill. She was silent. I asked her if she had ever valued any asset on a corporate balance sheet. More silence. Unfortunately, where proponents of fair value are concerned, I find this kind of reaction typical. They fail to account for fair value’s significant defects, including huge compliance costs, the dubious offsetting value for investors, and the invitation to moral hazard for company managements. Moreover, as this article explains, the advocates fail to consider important research findings. A better grasp of two concepts essential to understanding competition in market segments, along with certain modifications to FAS 157 (Fair Value Measurements), is needed. We must make fair value more relevant, more objective, more transparent, less susceptible to moral hazard, and less expensive for all involved. Problem #1: “Exit Value”

It is possible, if not entirely likely, for “exit value” to lead to an acquisition being accounted for at something other than its announced price. On its face, that is absurd. In its zeal to avoid “the Enron problem,” where insiders valuing derivatives made millions of dollars from overvaluation, the Financial Accounting Standards Board (FASB) has greased the skids for avoidable market volatility that might depress equity prices. For example, in the revision of FAS 141 (Business Combinations) scheduled to take effect later this year, exit value eliminates the capitalization of transaction costs. Does that mean that installation costs of a piece of machinery should also be expensed because they, too, are not recoverable upon sale? This bizarre notion announces that the bazaar is open: By mandating the recognition of changes in asset values on the income statement, FASB encourages managers to focus on accounting issues rather than on running their businesses. Many investors are far more interested in operating performance than they are in “Level 3 abstractions” about what hard-to-value long-lived assets might be worth. Might. Problem #2: Switching Costs

The problem of exit value is exacerbated by switching costs. These are the one-time costs a buyer incurs to adapt, inte-

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grate, and learn to use new assets. For instance, PC users know the deficiencies in the Windows operating system. Yet they are reluctant to switch because there are risks and costly learning curves associated with Macintosh or Linux and the software applications that run on those platforms. As William G. Shepherd and Joanna M. Shepherd note in The Economics of Industrial Organization, “Purchasers of complex equipment [or intangible assets] often must invest in specific training and associated equipment, which can be used only with that complex equipment. The buyer becomes locked in to the equipment. Switching to different systems becomes costly.” Common sense tells us that prices obtained from buyers of long-lived assets, especially intangibles, will be net of switching costs. The understatement will vary because switching costs will differ among buyers. This is further evidence that exit-based pricing distorts financial reporting. Problem #3: “Market Participants”

In its 2001 release of FAS 141, FASB defined “market participants” homogeneously. Homogeneity’s origin is in neoclassical economics with its unrealistic assumptions about decision-makers having perfect information, perfect competition, equilibrium, no innovation, no entrepreneurs, predefined choice set, maximization of personal utility, and so on. FASB embraces the neoclassical model nonetheless. FAS 157 states, “The fair value of the asset or liability shall be determined based on the assumptions that market participants would use in pricing the asset or liability.” Implicit in that statement is the view that a consensus exists. Homogeneous perceptions would underpin any such consensus, yet FASB seems unaware of research that debunks homogeneity. In a meeting I attended at FASB headquarters on 27 September 2007, I asked three Board members what they thought about “heterogeneous competitors.” None had heard of it, but they’re not alone. Barely a month later, on 31 October, former FASB member Ed Trott, arguably the prime force behind FASB’s swan dive into the empty swimming pool of fair value accounting, spoke at the annual business valuation conference of the American Society of Appraisers and said that appraisers should quit fighting FASB on fair value and “Just get over it.” Those of a similar mind-set might want to consider the evidence. Nine studies dating to 1991 indicate that variation in rate of return (ROR) caused by internal firm-level factors is about 2.9 times the variation in ROR arising from external industry-level factors.1 In other words, variation in ROR is greater within industries than across them. Thus, companies Continued on page 55


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Point

Counterpoint

“Economic Realities,” Continued from page 52 value rules are unwarranted—for seven reasons. First, the suggestion that the rules have caused the credit crisis ignores the principal causes of the subprime meltdown—expansive monetary policies, rising household debt, lax lending standards, development of financial engineering techniques to originate and distribute credit finance, and declining real estate prices. Other factors, such as increasing credit spreads, rising defaults, and surging LIBOR, have aggravated the crisis. Rather than exacerbating or causing the crisis, fair value rules actually helped expose the deterioration in the credit market. Second, the application of fair value accounting increases information efficiency because it provides investors and lenders with current and complete estimates of a company’s assets and liabilities. In this way, it enables investors to make well-informed investment-related decisions. Providing investors with information about the economic reality facing companies reduces information asymmetry between company management on one side and investors and lenders on the other. Third, fair value measurement enables investors to assess the efficiency of management in terms of added value and risk exposure. So far, the rules have allowed investors to identify the extent of deterioration in the complex financial instruments held by financial institutions, which resulted from risky management decisions. Fourth, fair value accounting promotes transparent capital markets. Market participants are informed about the underlying economic condition facing companies, and banks have less ability to hide losses on deteriorating assets. In March 2008, when CFA Institute surveyed more than 2,000 of its members worldwide, 79 percent of the respondents indicated their belief that fair value requirements will improve transparency and contribute to investor understanding of the risk profiles of financial institutions. Some 74 percent indicated that they expect the measure to improve the integrity of financial markets. From the perspective of these investment professionals, a move away from fair value measurement could compromise market transparency and undermine investor confidence. Fifth, if we, as investment managers, yield to the demands to abandon fair value rules, what is the alternative? Surely, a move back to historical cost measures would be a step in the wrong direction. The historical cost approach is inappropriate for valuing most securities, especially complex financial instruments, because it does not reflect the current market valuation and obscures the economic impact of risky management decisions. For example, the deteriorating conditions that led to the U.S. savings and loan crisis of the 1980s and the Japanese banking crisis of the 1990s went undetected for a long time partly as a result of the application of historical cost accounting. If fair value measurements had been applied,

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the deteriorating situation would have been identified earlier than it was and corrective action could have been taken sooner. Compared with the historical cost approach, application of fair value accounting should hasten recovery from a financial crisis because fair value rules accelerate loss recognition. Sixth, despite the potential weaknesses of mark-tomarket models, fair value accounting still provides greater transparency than historical cost accounting. According to some critics, when fair value measurement is applied to financial assets in inactive and illiquid markets during a financial crisis, the results are misleading because assets are valued at deflated price levels. Moreover, critics of fair value accounting allege, the use of unobservable inputs in determining the value of Level 3 assets produces weak fair value estimates. These criticisms are not valid for two reasons: (1) The reduction in the normal volume of transactions does not imply the absence of an active market because the number of buyers or sellers relative to previous periods does not determine the distressed nature of a transaction. (2) Although mark-to-market models may contain significant unobservable inputs, the reported valuations are subject to intense scrutiny by auditors, appraisers, and regulators who can challenge management assumptions in deriving the fair value estimates. As a result, distortions resulting from unrealistic fair value estimates based on unobservable inputs are likely to be detected. Finally, the timing of calls for the suspension or scrapping of fair value rules is opportunistic. Where were the cynics when a number of financial institutions opted for the early adoption of FAS 157 during advantageous financial conditions? Was the motive for adopting the standard a year early driven by the perception that some of these institutions would benefit by applying the rules in a favorable financial climate? Rules that are good enough for booming market conditions should be good enough for deteriorating conditions. Be Fair with Fair Value

The application of fair value rules provides users of financial reports with information about the economic realities and risks faced by companies. This information enables investors, creditors, regulators, and other stakeholders to make wellinformed decisions. Simplifying or abandoning the rules would be a step in the wrong direction and a move away from increasing the transparency of capital markets. Because fair value measurements reflect underlying economic realities, banks that have made significant write-downs should return to profitability when the financial climate improves. So, let us be fair with the fair value rules and work toward transparent financial markets. Ahmed Sule, CFA, is an investment strategist at Diadem Capital Partners Limited in London.



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“Wearing Blinders,” Continued from page 53 within industries are heterogeneous, not homogeneous. These findings have four implications for fair value: (1) Heterogeneity among competitors means significant differences among them about which long-lived assets should be deployed and in what ways. (2) Those differences make for disparities in expected rates of return on those assets. (3) Different RORs arise from divergent inferences among “market participants” about the price of any long-lived asset. (4) Therefore, the consensus implied among FASB’s “market participants” is improbable. FAS 157 does concede that differences might exist among groups of buyers. Footnote 13, Appendix A, says, “While market participant buyers might be broadly classified as strategic and/or financial buyers, there often will be differences among the market participant buyers within each of those groups, reflecting, for example, different uses for an asset and different operating strategies.” “Different uses for an asset and different operating strategies” is the screen door on the fair-value submarine. In most industries, there are more than two groups of buyers. Enter strategic groups2, discrete cohorts of rivals competing along “shared strategic dimensions.” In his seminal book Competitive Strategy: Techniques for Analyzing Industries and Competitors, Porter discussed strategic groups at length. In lodging, for instance, there are at least six such clusters among the “Big 4” players (Hilton, Hyatt, Marriott, Starwood): luxury, full-service, select-service, extended stay, timeshare, and resorts. In Contemporary Strategy Analysis, Grant identified seven strategic groups within the world automobile industry and seven more in the global petroleum industry. The Situation Today

A Fix

Fair value for current assets and liabilities is likely here to stay. Despite recent grousing from financial institutions and private equity funds, retaining fair value for financial instruments seems reasonable. The reasonableness of fair value further down the balance sheet, however, is dicey. Is FASB’s definition of fair value workable with longer-lived assets? If so, how? If not, is there a remedy? The published research is clear: Consensus among market participants about the fair value of long-lived assets, especially intangibles, is unlikely. Therefore, let’s hope that FASB returns to fair market value (FMV). FMV should be the standard of value for long-lived assets and intangibles. According to Sec. 2.02 of IRS Revenue Ruling 59-60, which came out nearly a half-century ago, FMV is “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Most important, adopting FMV would shift the valuation of long-lived assets from exit value to entry value and away from “market participants”—that is, the actual price of actual transactions, not speculative prices predicated on transactions that haven’t happened and won’t. Using FMV would also reduce compliance costs, decrease volatility, and provide a framework for valuation that all constituencies already understand. Existing requirements for impairment testing of long-lived assets should remain in place, of course. Investors and creditors want to know what returns a company can generate from such assets, not what price the assets might bring if they were sold to an unidentified third party whose identity, if it exists, is pure guesswork. Fair value encourages managers to trade assets, not operate businesses. It discourages long-term focus on wealth creation. Besides, any investor who wants to know how much those assets are worth can appraise them. Using fair market value for GAAP and for tax purposes has a long tradition. The mechanics of FMV are well understood by investors, courts, registrants, closely held companies, auditors, regulators, and valuation professionals. Given the huge compliance costs, the published research, the dubious offsetting value for investors, and the invitation to moral hazard, fair-value reporting for long-lived assets should be discarded. At the end of the day, valuation and accounting are too important to be left to the accountants. Anyone who doubts that need only follow the audit trail in FAS 157 left by fair value’s true believers.

FAS 157 would likely not have emerged in its deficient form if FASB employed any permanent staffers with such valuation credentials as the CFA charter or the ASA designation. It doesn’t. It has only a lone interim “valuation fellow.” Its belated attempt to play catch-up with the ad hoc, authorityfree Valuation Resource Group is a step in the right direction but is not nearly enough. This is not to begrudge FASB its desire to prevent a rerun of Enron, where billions of dollars of derivatives were valued by the same people who created the instruments. In seeking to solve that problem, however, FAS 157 invites greater volatility, more earnings management, and self-determined bonuses on a grand scale. It also will impose significant costs on registrants with little offsetting value to investors, even as those in the present author’s line of work reap a financial bonanza. By ignoring how an investor could obtain the values that A PDF summary of the nine papers is available by e-mailing the author at [email protected]. “market participants” perceive for Michael S. Hunt, “Competition in the Major Home long-lived tangible and intangible assets, Appliance Industry,” unpublished doctoral dissertaFASB gave the lie to homogeneity. tion (Harvard University, 1972). 1

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Warren D. Miller, CFA, is a cofounder and the managing member of Beckmill Research, LLC, in Lexington, Va.

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