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Fair value worth keeping

1 Dec 08

Japan a decade ago offers a lesson that politicians whose ears are being bent by banks with diminishing assets would do well to learn

by Glenn Allison

It’s not often accounting issues make the political headlines. Well, they have in the case of fair value accounting for financial instruments.

Leading politicians from the UK, Europe and the US have all had something to say about this issue. ICAS, for its part, submitted evidence to the Treasury Select Committee last month, as it considers the role of accountancy during the banking crisis.

The problem that fair value has given banks and others in recent times is that they believe that their financial asset prices have fallen below what they consider to be their true economic value – leading to very large writedowns. The scale of these write downs

has led to calls for the suspension of fair value accounting, which some people blame for contributing to the crisis.

At this point, it is important to point out that fair value accounting is not new. So why the current outcry? What’s changed? The answer is, of course, the current economic climate. The message appears to be that it is okay in the good times to show the fair financial position of an entity but when times get tough, transparency can be set aside.

The ICAS position is that fair value accounting did not cause this financial mess, it has simply brought the severity of the current crisis to the surface. As a former US Securities and Exchange Commission chief accountant put it, blaming accounting is like blaming the thermometer for the fever. So abandoning one of its main principles is only likely to reduce transparency and comparability, which will lead to a further erosion of investor confidence.

We don’t even have to delve very deep into the past to find a pertinent example which demonstrates the problems that would arise from changing fair value. The Japanese financial crisis of the 1990s was compounded and prolonged in part by a sub-standard accounting framework and a lax enforcement of that framework.

Japanese accounting standards at the time allowed financial instruments to be measured at cost. This meant that the accounts of the banks and other financial institutions were able not to show the real impact of the falling markets, and the government aided and abetted this by allowing them to bend the rules and delay recognising impairments.

The overall effect was that the true severity of the crisis did not become apparent until it was too late, and the Japanese economy was still feeling the effects many years later.

One of the subsequent steps taken to improve regulation was to introduce fair value accounting for financial instruments.

The Japanese experience shows us that the absence of up-to-date, transparent market information in the form of fair value valuations, causes investors to make their own estimates of the extent of the problem and these are often going to be inadequately informed and therefore unrealistic. This information gap will fuel uncertainty and erode confidence – leading to exactly the downward spiral that opponents of fair value are seeking to avoid.

In difficult times, it is natural to search for villains, but the case against fair values simply does not stack up. Now, more than ever, the markets need to be supported by reliable, consistent and comparable financial reporting, and retaining fair value measurement for financial instruments is crucial to this.

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Glenn Allison | President | ICAS

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