Did Fair Value Accounting Contribute to Financial Crisis?

To determine whether Fair Value Accounting contributed to the current crisis in financial markets, economists must examine the explicit and implicit connections of reported accounting numbers to the actions of the players in the financial markets and then ask whether such connections can create or exacerbate the problems that occurred over the last year, said Christian Leuz, Joseph Sondheimer Professor of International Economics, Finance and Accounting.

Potential connections include contracts (e.g., covenants and margin requirements), management incentives, and regulatory capital requirements, Leuz said during the opening of the Fair Value Accounting Panel, sponsored by the Accounting Research Center, at Harper Center on May 1. The panel was moderated by Phil Berger, Charles P. McQuaid Professor of Accounting.

“It’s important to see that, due to these links, accounting can have contributed to the crisis only in conjunction with other elements of our financial system,” Leuz said. “We should also talk about the possibility that we made mistakes in these other systems that tie into accounting, and hence that we are not necessarily facing an accounting problem.”

Fair Value Accounting actually helps freeze the market during a crisis, said Stanley Parzen, partner at Mayer Brown LLP law firm. “Under Fair Value, the most technical method to value a financial instrument is to look at market transactions and similar transactions,” Parzen said. “By selling into a market without many transactions, you may be establishing a market value which, in effect, is going to require you to take a loss. If everybody held and didn’t sell, you wouldn’t have to recognize that loss.”

Financial Accounting Standards Board Statement 157 did not introduce new accounting rules, but rather defined fair value accounting, said Marc Siegel, a member of the FAS Board. “The objective of fair value accounting has been and continues to be the value at which you would sell a security in today’s market, if you had a willing buyer and a willing seller in an orderly transaction,” Siegel said.

In an active market, that definition makes sense, he said. “The question becomes, when a market becomes less active or inactive, does the fair value concept still work?” Siegel said. “If you don’t have any sales of any securities out there, the objective remains the same: to estimate the value in a hypothetical transaction, if there were a sale between a willing buyer and willing seller.”

Tim Schott, partner at Deloitte & Touche LLP Complex Accounting, Regulatory & Capital Markets Consulting, called the current financial crisis a “very challenging period” for auditors. “A lot of people did not understand the complexities of the assets they owned,” Schott said. “It wasn’t a big deal at first because they could go to a Bloomberg screen and get a price.

“But it was a painful pill for clients to swallow later when we tried to explain to them, ‘You need to hire someone to forecast these cash flows and come up with a very sophisticated valuation model. Or we will say that you don’t have adequate controls over your ability to fair value your own portfolio. Therefore, we would not be able to provide an opinion on your financial statement.’”

The ongoing debate about the accounting of troubled assets in the current financial crisis attracted first-year student Matt Marchel to the panel, he said. “One of the issues is, what information is being relayed to investors versus to regulators?” Marchel said. “Especially having (FASB Member) Marc Siegel on the panel provided a very interesting perspective on these issues.”

Read “The Crisis of Fair Value Accounting: Making Sense of the Recent Debate” by Leuz and Christian Laux.

                                                                                                                    — Phil Rockrohr