As we have seen since Chapter 1, fair value, which is one of the keywords reflected in the title of this book, is a pervasive subject, and a fairly controversial one particularly in connection to financial reporting. The first encounter the reader of this book had with the definition of fair value was in Chapter 3 on the dynamics of IFRS (as defined by FASB). The term has also been extensively used in section 3 of this present chapter.
It has been a deliberate choice not to limit the discussion of fair value to one chapter, but to spread it throughout the book. At the risk of being repetitive, this provides a better assurance that the reader will gain a full appreciation of this important subject because fair value benefits and challenges are treated in closer relations to the problems that arise. In this sense:
● Chapter 10 discusses fair value in connection to valuing the entity’s assets
● Chapter 12 introduces fair value concepts into forward-looking statements
RETURN
HIGHER LOWER
ASSUMED RISK HIGHER
LOWER
TAPERING OFF
UNWANTED EXPOSURE
WANTED EXPOSURE
GREY AREA
LOW RETURN HIGH RISK
Figure 4.1 Risk and return are correlated nonlinearly. Investors must appreciate the shape of the risk and return curve
● Fair value enters into Chapter 15 because its theme is virtual balance sheets, and
● In Chapter 16, fair value is examined in terms of impact on stress testing and the computation of relative risk.
The careful reader will recall that SFAS 133, by FASB, was the first to put stress on fair value financial reporting. IAS 39 came right after and the resistance which it encountered encapsulates much of the debate in the accounting profession over what worth to ascribe to the items in a company’s inventoried positions. Chapter 1 mentioned FIFO, LIFO, and weighted average, as methods widely used for valuing inventories of physical goods at original cost. These were developed for physical inventories; they are not good for financial instruments.
As we saw in section 3, today in Europe many banks are disputing whether fair value accounting gives a really more meaningful insight into their economic per- formance, and their assumed risks, than historical measures. Chapter 2 has men- tioned that many insurers have a similar critical position. Both bankers and insurers, however, fail to offer a better alternative, by all likelihood because they do not know what to suggest.
While American banks are accustomed to fair value accounting, because Statement of Financial Accounting Standard 133 is already 5 years old, and they have got accustomed to it, many EU banks and financial services companies are complaining about the introduction of market values for their business. As we have already seen, a fairly superficial argument by IAS 39 opponents is that it would lead to volatility in income statements, which:
● Will reflect its exposure to the oscillating derivatives markets
● But would not necessarily capture the ‘underlying economic performance’
of the company.
This argument is near-sighted, because it forgets that volatility is embedded into the banks’ books because of the financial instruments which they contain, and most particularly the ever-growing amount of risky derivatives products (see Chapter 5).
As a suggestion, a more sophisticated approach to fair value, but one that is alien to the way of thinking of most people, would be based on possibility theory.
Probability theory, in which most students are trained today, is a special and rela- tively limited case of possibility theory and its fuzzy engineering applications.4 A simple example of fuzzy sets is how long it takes to drive from Monte Carlo to Lucerne through the Gotthard tunnel. On the average it may take 6 hours (the fair
value), but it is equally likely that it would take 5 h 45 min or 6 h 15 min. As Figure 4.2 shows, it is less likely, but still possible, that it takes 5 h 15 min (if traffic is light and weather conditions are good), or 6 h 45 min (if traffic is heavy and weather conditions are bad).
Let’s turn this example into buying and selling financial instruments, or any other product. The product may have a ticket value, a willing buyer is likely to negoti- ate the price asked by a willing seller – unless the willing buyer cannot imagine life without the product or service he or she wants to acquire. Notice that varia- tions to fair price are fuzzy sets, depending on how the negotiation goes.
● Such variations are not margin of error.
● They are a negotiating margin, inherent in any fair value.
Contrary to the flexibility and relative accuracy of the possibilistic model we have just been discussing, because of its emphasis on historical costs, which in most cases have become irrelevant, accruals accounting masks the true perform- ance of a company – whether it is prosperous or in trouble. It is not historical costs but market valuations of a company’s assets and liabilities which can be
1
MAX–MIN 5 H 45 MIN
MIN–MAX 6 H 15 MIN
0
MAX–MAX 6 H 45 MIN MIN–MIN
5 H 15 MIN
DRIVING HOURS
Figure 4.2 A possibility theory distribution: timeplan for driving from Monte Carlo to Lucerne over Gotthard
revealing to investors and regulators, though they could make entities with a deteriorating financial position show up their frail status.
Transparency never harmed anybody, if that body had nothing to hide. Ifmany companies and (curiously enough) some heads of EU governments are uncomfort- able with the way IAS 39 makes bad hedges transparent, it is because they have things to keep out of public view. By (correctly) obliging them to show the value of instruments they use, IFRS renders every stakeholder a great service. Politicians, however, have very short-term priorities, and the European Commission tried to brokerage a bad compromise by:
● Removing the requirement for companies to mark to market instruments used in hedging, and
● Deleting parts of the fair value option, to placate those who have good rea- sons (of hide and seek) to oppose it.
Experts say it is unclear how this EU version will work in practice. But most wor- rying for many in the accounting profession, as well as among regulators, is the precedent set by political interference in what should be an independent standard setting process. I had a professor at UCLA who taught his students that ifyou let a company choose its accounting system, thenit can prove anything it likes.
Accounting standard and risk management rules should not be subject to lobby- ing. Political lust and greed is totally opposite to rationality. For instance, insur- ers are urging the IASB not to restrict the use of the fair value option too much.
They say the IAS 39, post-EU interference, would make the fair value option dif- ficult for them to apply. In essence, IASB is trying to strike a balance between:
● Allowing practical use of fair value, and
● Meeting the concerns of insurance firms who keep their hedges (read: spec- ulations) close to their chest.
It is indeed most interesting to notice that while some politicians, who do not necessarily understand much about accounting and fair value, declared them- selves against IAS 39, European insurers have called on the International Accounting Standards Board to preserve it. In mid-January 2004, the Comité Européen des Assurances (CEA), which represents national associations of insur- ers in 32 European countries, criticized proposals to limit the fair value option.
The CEA wants the European Commission to enlarge the fair value option it has endorsed, with a workable alternative that would allow insurers to measure both
financial assets and liabilities at fair value. On the other side of the fence one finds the European Union’s internal market Commissioner; and other politicians.
The Commissioner warned whoever would listen that the drawing up of stan- dards was ‘not just a technical exercise’, adding: ‘There is a question: What is the political accountability in this area?’5
A nice, simple, and accurate answer to this query is that ifat the end of the 15th century Tuscany’s politicians had interfered with the work of Luca Paciolo, we would not have had for more than 500 years a sound and functioning account- ing system.6It is the great wave of new, complex, and risky financial instruments which now makes mandatory the revision of the 1494 rules:
● This must be done in a sound and rigorous manner,
● Without the politicians making a mess out of it.
This case of political interference with accounting standards setting is serious – not only because European Commissioners are not elected officials, which makes a mockery of democracy. A statement once made by Rufus Choate, the great American lawyer, fits well situations like this: ‘I should guess, from his bearings, that he is wondering whether God made him, or he made God!’7 It is, precisely, part of political accountability to explain the reasons of IAS 39 to companies that suddenly find that marking to market derivative instruments ends in major swings on corporate profitability. Behind the swings lies the fact that they have overloaded themselves with toxic waste. IAS 39 is only the mes- senger; and it is bad policy to shoot the messenger:
● Because derivatives are leveraged instruments, measuring fair value in the short term makes profit and loss results volatile.
● Since this is something the market dislikes, even if the P&L swing is posi- tive, companies should be prudent to avoid derivatives overleveraging.
Indeed, the very positive result from implementation of IAS 39 is that it brings the hazardous use of derivatives instruments, by many firms, to light. Some Italian industrial groups, not only Parmalat and its likes but also bureaucratic entities, provide an example of the aftermath of going bust for the sake of ‘good- looking profit figures’.
When in 2004 PriceWaterhouseCoopers replaced Ernst & Young as the certified public accountant of Poste Italiane, Italy’s state-controlled post monopoly, it implemented IAS 39 on its statements for the last four years. This demonstrated
that Poste Italiane had incurred a 104 million euro derivatives loss, mainly due to exotic swaps the bureaucrats had entered into in 2000.
● Most were quanto dollar swaps, a combination of interest and foreign exchange rates, and
● This is a derivative instrument well beyond the bureaucrats’ skills or understanding of what they were doing.
When in December 1995 California’s Orange County went bust, after having leveraged its $7.5 billion to $21.5 billion through collateralized mortgage obliga- tions (CMOs) and other derivatives, the County’s Treasurer and his associates were prosecuted. They stated something similar to their colleagues at Poste Italiane in their defence: that they did not understand the instruments. If one does not understand what one is doing, thenbetter to go home (or to prison); one should not take other people’s money to the edge.