A long-standing criticism of historical-cost accounting (HCA) is that, while it may provide good information about things that already have happened, it may not tell us much about what has happened in the recent past or what is likely to happen in the future.
For example, a bank may have acquired a bond some time ago at a price of $100, but it might be possible to sell the security today for only $80. If the bank classifies the security as "held to maturity" and believes that it will pay off in full at maturity, it is allowed to carry the security at $100 and need not recognize any loss when reporting its earnings and capital.
Fair-value accounting (FVA) is a framework for assigning current values to assets and liabilities. In the example above, a loss of $20 would be recognized both in the bank's earnings and its capital as soon as it occurred. The bank would have no choice, even though it might believe there has been no permanent impairment of the security's value.
Many academics, policymakers and others have applauded FVA as a vast improvement over HCA, because it is likely to accelerate the recognition and (hopefully) resolution of troubled banks and other financial firms. At the same time, some bankers, politicians and others have derided FVA as a principal cause of the financial turmoil we are experiencing because it translates financial-market volatility into wild and largely unjustified fluctuations in banks' earnings and capital.
In fact, both extreme positions are wide of the mark. FVA is neither perfect nor pernicious in its own right. There are many difficult conceptual and practical issues surrounding FVA that remain to be resolved. In the meantime, all concerned parties should learn more about FVA and work toward a more effective implementation. Fair-value accounting is just the messenger and it wouldn't be wise to "shoot it down" just because the message it is bringing today is unpleasant.
U.S. GAAP (generally accepted accounting principles) has been moving toward FVA principles for a number of years, but GAAP remains a hybrid system. That is, it is an evolving mixture of historical-cost, LOCOM (lower-of-cost-or-market) and fair-value accounting principles.
As of late 2007, banks and other firms may choose to apply fair-value principles to any financial asset or liability, but they need not do so in some cases. Certain items, such as derivatives, always must be reported at fair value. Others, such as loans, rarely are. Liabilities may be marked up or down to reflect changes in fair value, giving rise to the paradoxical implication that a firm's financial difficulties actually may increase its earnings and capital. For example, a bank that has issued $100 million of debt may increase its earnings and capital by $10 million if its debt is trading at 90 percent of par in the secondary market.
The "fair-value option" is explained in FAS (Financial Accounting Standards) 159. If choosing FVA for a loan, security or liability, a bank applies the "fair-value hierarchy" spelled out in FAS 157. In particular, an asset or liability is reported at market value, if a price is available (a level-one valuation); at a value derived from a closely related market price or prices (a level-two valuation); or at a value determined by a valuation model, such as an estimate of the values of the asset's discounted cash flows (a level-three valuation).
As currently implemented in U.S. GAAP, relevant FVA standards are intended to answer how much a competent liquidator would receive for this asset, and how much it would have to pay to extinguish that liability, in a non-distress transaction under normal market conditions.
This statement of its intent shows that application of FVA struggles with at least three difficult problems:
First: The "exit-price notion" of fair value is a liquidation value, which may differ significantly from an asset's or liability's "value in use." It disregards any "going-concern value" that may be attached to a particular asset or liability, such as the value of a bank-borrower relationship, market-specific knowledge, or a core-deposit franchise. Thus, FVA may materially misrepresent the economic value of a viable bank, as distinct from the sum of its component assets and liabilities if transferred (hypothetically) to another bank. Note, however, that historical-cost accounting also may report an enterprise value far from the total market values of a viable bank's debt and equity.
Second: FVA is highly subjective whenever there is no deep and liquid market for one of the bank's assets or liabilities. In these situations—much more common today during the financial turmoil than in years past—FAS 157 details valuation techniques based on "close substitutes" (a level-two valuation) or a discounted-cash-flow or other model-based valuation (a level-three valuation). These valuations require expert judgment and are likely to differ significantly across banks and from day to day when financial markets are volatile.
Third: In important respects, application of FVA under GAAP is voluntary, and thus makes comparisons across banks more difficult. Some banks will report a larger proportion of their assets and liabilities at fair values than others, making standard accounting ratios difficult to interpret.
The financial crisis has demonstrated a key advantage of FVA in providing relatively prompt updates on the financial conditions of some banks and other financial firms. But it also has highlighted some of FVA's weaknesses. Moreover, the Financial Accounting Standards Board in early April issued clarifications of several FVA statements. FASB said the clarifications would make the fair-value framework "more flexible" by encouraging banks to use their own judgments more often about whether the markets used for valuation purposes were "not orderly." This will increase the frequency of level-three valuations, in particular.
While FASB was criticized by many for "compromising" or "weakening" FVA, it's more accurate to say that FASB merely has altered the elaborate compromise represented by GAAP's incorporation of fair-value principles. A similar controversy is raging around accounting standards outside the U.S.
Fair value is neither a perfect accounting framework nor more inherently flawed than any other approach. Ironically, the prominence of fair-value accounting principles in U.S. GAAP increased just as the financial crisis was unfolding. It would be a mistake to blame FVA for the crisis, but we also should learn from recent experience that its application has been problematic.