Chapter 8 has defined what management accounting is and is not, as well as the advantage a company gains by bringing closer together management accounting and financial accounting. It is therefore a ‘plus’ that in European and other coun- tries applying IFRS, listed companies have to use fair value for presentation of their consolidated financial statements. To obtain a wider appreciation of fair value accounting, and get insight into possible consequences, including:
● Customer relationships
● Types of products offered
● Risk management practices, and
● Financial staying power
it is wise to look back in time at the very origins of the method in the post-World War II years. Also, at the debate which took place at the time, prior to its con- version into regulatory requirement. This first time fair value accounting became the letter of the law is in connection to US GAAP in the late 1990s.
As the Introduction brought to the reader’s attention, in the last three decades of the 20th century valuing assets in a way different than classical book valuehas been the strength of corporate raiders, who were able to see further than others.
Because being ahead of the curve is one of the secrets of success in business, it is good news that fair value has become the generalized new accounting regime which can affect every entity and every process. This includes:
● Banks as financial intermediaries
● Insurers as providers of basic social services, and
● The distribution of financial risks among economic agents.
At the very origin of the new financial reporting regime have been the hearings by the US House Banking Committee, Subcommittee on Capital Markets, Securities and Government-Sponsored Enterprises. Held on 1 October 1997 they focused on implementation of proposed new rules for financial reporting formulated by the
Financial Accounting Standards Board (FASB). Effective as of 1 January 1999 these rules required that all publicly traded corporations, including banks, report their derivatives holdings on their balance sheets at fair market value. That is the first official case on record.
During these hearings, then FASB Chairman Edmund Jenkins testified that his board’s primary focus was to put into effect rules that would require all firms, whether financial or industrial, to report their derivatives holdings, on balance sheet and off-balance sheet (OBS), by marking them to their current market price.
This started the fair value accounting ball rolling. Jenkins’ testimony included important references to:
● Why it isimportant to use market value in financial reporting, and
● Why accruals no more fit the modern economy’s requirements.
The evidence was fair and well documented. The way the FASB chairman put it:
‘If ever a case can be made for reporting something in more detail, it is for deriv- atives. … Different companies may report very similar activities differently, and even an individual company may report similar activities differently. … Gains and losses (on derivatives) are not explicitly disclosed today, and their effect on earnings is difficult, if not impossible, for an investor or creditor to determine.
Again, we believe that the public has the right to know.’
What Jenkins did not say, but today can be added with certainty, is that the com- pany’s senior management, too, has not only the right to know but also the responsibility to appreciate all the details about recognized but not yet realized gains and losses. This is as true with derivatives as it is with all other instru- ments in the institution’s:
● Trading book, and
● Banking book.
Fair value evidence brings regulatory financial reporting and internal manage- ment accounting very close together. Moreover, as far as public scrutiny is con- cerned, years of implementation of fair value accounting in the United States, following the issuance of Statement of Financial Accounting Standard No. 133 (SFAS 133), have demonstrated that Edmund Jenkins was right.
The more its critics riot against fair value, the more they (unwillingly) prove that the FASB thesis has been sound. Its board was unconvinced by the argument that
‘derivatives are just hedges’. True enough, reporting recognized but not realized profits and losses from derivatives on balance sheets, impacts upon reported earnings. This, however, happens because of:
● The huge amounts of red ink treasurers and bankers have recorded with derivative financial instruments, and
● The fact that with accruals red ink was hidden from public view, but it is now becoming transparent by writing them at fair value into the balance sheet.
A day prior to Jenkins’ testimony, on 30 September 1997, the Wall Street Journal reported that during the third quarter of that year, Salomon Brothers, the invest- ment bank, had lost at least $200 million in derivatives. At the time, experts at Wall Street said the actual money lost could be much higher – and Salomon was only one of the top eight US financial institutions active in derivatives.
An interesting statistic to keep in mind is that in 1997 the top eight US deriva- tives-holding commercial banks had $22.6 trillion worth of derivatives in notional principal amount, against only $93 billion worth of equity. The deriva- tives holdings of non-financial corporations were also very large, and growing rapidly as more and more entities thought that they had discovered a new Eldorado off-balance sheet.
How rapid has been the growth of derivatives exposure can be attested by the fact that, according to published figures, at the end of 2004 the derivatives expo- sure of just one bank, JP Morgan Chase, stood at $45 trillion(in notional princi- pal). This is 200% higher than the derivatives exposure by all eight top US commercial banks just seven years earlier.
At the time of the 1997 hearings, FASB also exposed in the US House hearings that several companies had adopted the curious way of reporting losses as increasesin valuation of their assets. That’s creative accounting at its best. The American accounting standards setter stated, at the House hearing that: ‘The information about derivatives and hedging reported in financial statements today is incomplete, inconsistent, and just plain wrong.’2
At the time, Edmund Jenkins responded to repeated calls for non-transparency in derivatives trades made by the guilty parties, by saying that ‘gains or losses on derivatives that qualify for hedge accounting should have little or no effect on a company’s earnings because they will be offset by comparable losses or gains on the thing that is being hedged – and the result is little or no volatility in earnings.’
Seven years of experience with fair value financial reporting in the United States has proven that:
● Balancing-out is true if, and only if, hedges are not speculations – as is so frequently done.
By contrast, if the hedge is not matched by, and does not move in the opposite direction from the underlying instrument, then:
● At best the hedge operation was not an effective hedge, and
● At worst it was mere speculation masquerading as hedge.
It is, in fact, a common practice that the hypothetical hedge is in reality a spec- ulative investment, or trade, which ended in money losses, as many of them do.
The answer to those gamblers evidently is that banks as well as all other quoted companies should not be speculating with their shareholders’ and depositors’
money.
It is quite interesting to keep in mind that, during his 1997 testimony, Jenkins revealed some creative accounting practices which alter the true value of balance sheet reporting. But contrary to the thesis by FASB and the Securities and Exchanges Commission (SEC), the Federal Reserve was not happy with the new regulations making it mandatory to reveal to regulators, investors, and the general public the whole extent of a public company’s exposure – and for good reason.