fair value accounting

#1

what exactly is fair value accounting? and how does it relate to the credit crunchh?

also, regulators are being blamed… so have there been any changes or proposed changes in regulation recently?

#2

Fair value accounting means the reporting of the value of assets at their current market value. In other words, a bank would report its debtors at the value it is owed, or what it would be worth if it sold that debt to another bank.

One major fault of fair value accounting that has become apparent in the current crisis is that despite the fact that this money owed to the banks was saleable to another bank for a large amount of money, if the debt were to be called in then they would find nobody could repay, and therefore the debt was worthless- or in other words, the value was much less than the estimated market value.

In other words, banks had lots of assets at fair market valued prices, in an overly inflated market, which actually turned out to be worthless- hence audinng firms will need to take additional consideration when calculating the value of assets in future.

In terms of a regulation change- there certainly will be regulation changes, but so far I believe there have been no significant regulation changes to prevent this from reoccurring. It is worth pointing out that the financial industry is already very tightly regulated.

#3

Valuing a financial instrument at fair value is also made considerably more difficult by the liquidity of the instrument.

e.g. It’s very easy to value and liquidate a futures contract for Brent crude as it’s traded on an open exchange; it is a homogenous commodity, with a fixed volume and quality.

However the problem comes with over-the-counter derivatives - that is bespoke contracts; the classic example is the credit default swap - where one party essentially pays for the insurance of a debt if the creditor defaults. Since these contracts are between two parties (and not traded on an exchange) it’s almost impossible to determine the market value without actually selling it on the open market - much like your house. It’s someone’s best guess.

The banks have been recognizing as profit changes in the market value - something called Fair Value through Profit and Loss. This is allowed by the International Financial Reporting Standards; a set of standards most of the developed world is looking to adopt. In actual fact, UK GAAP would recognize the change in value as equity (unrealised profit).

My apologies if this is getting too technical, but the point is that many companies were overstating their profits and the value of their assets in times when the market was strong. Hence why we see all these write-downs. The auditors to be fair don’t set the standards, they come to an opinion on whether the financial statements are prepared in accordance with them.