Unfair Value

Fair value accounting was introduced ostensibly to provide more relevant information to people reading financial reports. Historical cost accounting, based on the price a company originally paid for its assets, was deemed irrelevant. That's the theory. What about the practice?

Opponents of fair value accounting often argue that, in practice, it is unreliable. Managers, they claim, will just invent numbers to make their accounting reports look good. Historical cost, according to these critics, is more reliable because the values being reported can be verified by auditors just by looking at receipts and other transaction records. This makes it harder for managers to exaggerate the value of their assets.

A reliable diving board is still a diving board.

This is the wrong thing to be worried about. It's not unreliability that is the problem with fair value. In practice, fair value tends only to be used for things where there is a clear market price, such as financial securities. The price of these on any given day can be easily verified just by looking it up online. Managers cannot exaggerate anything when it comes to the price of a publicly traded stock or bond.

There are two much more important problems with fair value accounting. The first has to do with how markets fall short of perfection, and the second has to do with volatility.

Imperfect Markets

The first problem with fair value accounting crops up when the "market" that produces the market price of an asset is less than ideal. The entire notion of fair value -- the "fair" part of it -- is that the price of the asset being exchanged must be unbiased. It cannot favour the buyer or the seller. This depends on both parties being fully informed, willing, and at arm's length from each other. In other words, no collusion!

No market is ever perfect, of course, but the major financial exchanges like the TSX, NASDAQ and so forth are usually good enough for practical purposes. Financial securities on these exchanges are typically traded between reasonably informed buyers and sellers operating at arms length. There may be huge information asymmetries between the company that issues a stock and its stockholders, but between stockholders, the information asymmetries are less of a problem. The buyers and sellers are equally uninformed.

For non-financial assets, fair value accounting is usually avoided. It is time-consuming and costly for independent appraisers to assess the value of non-financial assets, and the results can be less than precise when it is a unique asset, such as a steel fabrication plant that cannot be moved anywhere or used for any other purpose. Historical cost does a good enough job of accounting for such assets, and the depreciation is all handled automatically by the accounting system.

When fair value accounting is used for non-financial assets, it is usually because the payoff for the parties involved is greater than the cost of determining the fair value. Take the case of China...

Fair Value in China (2000-2001)

As part of the modernization of its economy, the Chinese government introduced fair value accounting regulations gradually over the period from 1998 to 2000. A year later, in 2001, they threw those regulations out and reverted to historical cost. Why?

What happened was that Chinese companies started taking advantage of fair value accounting to turn their losses into profits. Magic!

The problem wasn't with the wording of the regulations. China's fair value accounting standards were largely consistent with the international standards in effect at that time. They required all business firms to use fair value for measuring assets surrendered, received or exchanged. Any resulting gain or loss was to be recorded in the current period’s net income.

To avoid shenanigans, gains could not be recognized in an exchange of similar assets. Two companies couldn't just swap all their delivery trucks or office chairs and claim that their assets had increased in value. However, firms found a way around this. They colluded with each other to exchange dissimilar assets, so they could record a gain anyway. Here is how it worked:

Suppose a firm had a valuable factory that was old enough to have been depreciated substantially under historical cost accounting, and suppose it was also in debt to another firm for a large amount. Perhaps the other firm was a bank that had lent it the money to build the factory. The factory-owning firm could use the current market value of the factory (assuming it was higher than its depreciated value) as collateral in restructuring the debt, effectively exchanging the factory for new debt and cancelling the old debt. This allowed the firm to recognize a gain on the factory, because the "fair value" of the factory was demonstrably equal to the amount it had as collateral for the other firm. After all, this other firm had agreed that the factory had that value. Market value. Fair value.

The difference between the large collateral amount and the small depreciated cost (the "carrying value") of the factory on the firm's balance sheet would be recorded as a gain on the firm's income statement. The gain would inflate the earnings of the factory-owning firm. In fact, if the firm had previously been losing money, the gain might be enough to allow it to show a profit for the year. This is what was meant by "turning losses into profits."

This would almost never happen in situations where companies were completely independent of each other. However, in China, companies were often not completely independent of each other. The Chinese government was always the majority shareholder of each company, and in addition, the companies might be related in numerous other ways such as partnerships and joint ventures.

Remember, the accounting regulations for fair value in China were based on international regulations, intended for countries like Germany where the financial markets and corporate ownership structures were very different. The problem was not that Chinese firms were somehow more corrupt than firms in Germany. It was that the assumptions behind these fair value accounting regulations did not hold in China. The conditions for exchanges between companies in China were nothing like the conditions prevailing on the Börse in Frankfurt.

This was not even the only fair value scandal in China at this time. A large number of firms transferred proceeds from equity offerings to their majority shareholders, who were often politically-connected administrative supervisors of the firms, by creating non-monetary transactions using fair value rules. This greatly hurt the interests of smaller shareholders and the credibility of the stock exchanges in Shanghai and Shenzhen, which were only ten years old.

After a year of watching this behaviour, accounting regulators in China tore up their fair value accounting regulations. They did reintroduce them a few years later, in 2006, after a lot of work on accounting institutions and training. However, the debacle of 2000-2001 was a chastening experience for proponents of fair value accounting, both in China and internationally.


Economic Instability

The second basic problem with fair value accounting has to do with volatility. Historical cost accounting produces predictable asset values. Fair value depends on market prices, and as anyone who has been saving for retirement knows, the financial markets have been anything but predictable for the past two decades.

One of the assumptions of financial markets is that, on average, the prices paid for securities tell us what the value of the security is. One buyer might overpay, another might underpay, but on average, the price is correct.

This is basic statistics. As long as the prices of individual transactions are randomly distributed around the average, the underlying conditions of market theory hold.

When transactions start to correlate, we've got a problem. Take the case of the United States ...

US Subprime Mortgage Crisis (2008)

In the mid-2000s, US banks saw their stock prices go up because interest rates were low and many people were borrowing money to buy new houses. Because banks executives could make a lot of money by keeping their stock price on the rise, they gave incentives to bank employees to keep selling mortgages, even when prospective homeowners might not be able to afford the mortgage payments. These customers could just be charged a higher rate of interest on the loan, to make up for the bank's risk. Mortgages with higher interest rates were called "subprime" mortgages because they were sold to people who could not qualify for prime interest rates.

The financial benefit to bank executives in having the stock price go up was worth the risk of seeing individual mortgages go into default. (Let's be clear about what this means. Bank executives were willing to try earning huge bonuses for themselves at the risk of putting their customers into bankruptcy.) The banks were compensated by charging higher interest rates on individual loans. But this was not the end of it. The banks had another trick up their sleeves.

As more and more risky loans accumulated on their books, the banks began to sell portfolios of these loans to other banks. The idea of a portfolio is that while any individual loan might go sour, it would be very unlikely for all of them to go sour.  This made the portfolio inherently more stable than any individual loan. By pooling the risky loans together and selling them as a group, the consumer bank passed the risk on to a commercial bank, which was able to diversify the risk over a greater number of loans. But the banks were still not done.

The next step leading to disaster was for some financial genius at an investment bank to realize that you could create portfolios of portfolios. If you took all the portfolios of loans from the commercial banks and pooled all their cash flows together, you could direct the cash flows to one tranche of loans first, with the remainder of the cash flows going to a second tranche, and then whatever was left after that going to a third tranche. Create a financial security derived from the first tranche of loans and there is almost no chance it would ever fail to pay off, because it consisted of all the loans that got paid first. This security could be sold at a premium price on the financial markets. A similar derivative created on the second tranche of loans would also be pretty solid, and could be sold for a lower but still decent price. It was only the third set that was risky. That's where all the loans would be that might not get paid. And if you sold a derivative based on this tranche for a cheap enough price, it might still pay off for an adventurous buyer.

Strange as it sounds, this is all fine and dandy -- as long as the assumptions of statistics hold. When those assumptions fail, the entire house of cards can collapse. And collapse it did.

The assumption that failed was the one that said all the transactions have to be random. If they start correlating, the financial model is no longer valid. The correlation came from US mortgage laws. These laws permitted homeowners to treat interest on their home as a taxable expense. This encouraged them to take on mortgages that they couldn't really afford. The laws also permitted them to walk away from a mortgaged home if they couldn't make the payments. In Canada, if you do this, you still have to make the loan payments. In the US, the home was just turned over to the bank and the mortgage was cancelled.

When property prices continue to rise, the market value of homes is always worth more than the balance of the mortgage. No one walks away from their mortgage. But with people mortgaged to the hilt (some banks were offering negative equity loans in an attempt to keep their gravy train rolling, so people would buy a new home and receive a mortgage worth more than the purchase price, giving them extra money to play with, trusting that in time, the market price of the home would increase above the mortgage amount), the margin of error for many families was razor thin. If either parent got laid off, they wouldn't be able to afford their mortgage payments and they would have to sell. If they couldn't sell for a high enough price to pay off the mortgage, they would walk away, leaving the home to the bank. Whenever several people in a neighbourhood did the same thing -- and they did because layoffs usually affect many employees at once -- the bank was left holding several empty houses.

And what does the bank try to do with these? Sell them! And when several houses in a neighbourhood are all on the market at the same time, the market price goes down due to oversupply.

This causes the market price of all the other houses in the neighbourhood to drop, putting more and more homeowners "under water" on their mortgages, even if they weren't laid off. So they walk away, too. A vicious circle. A downward spiral.

It gets worse. Because the banks were using fair value accounting to disclose their asset values, the balance sheets of the banks collapsed. With them went the bank stock prices. And of course, that's when the bank executives began to complain, because their gravy train had stopped.

The bank executives turned to the US government, saying "You've got a problem here." And the US government bailed out the banks. The government figured that the cost of the bailout was less than the cost to the economy of the banks collapsing.

No one bailed out the people who lost their homes.

Unfair Value

The bottom line here is that fair value accounting is risky because it depends on a whole lot of assumptions that may not always hold. In China, the assumption that market transactions are at arm's length was violated. There was collusion. This was predictable because markets are never perfect. Economists and financial gurus often forget this.

In the US in 2008, the assumption that market transactions are random was violated. Markets are volatile and they are susceptible to sudden negative correlations. But we always forget this. Like eternal optimists, we start building the house of cards all over again.

So am I against fair value accounting? No. What I'm against is financial and accounting regulations that protect the wrong people. We constantly ignore the fact that the impact of accounting scandals and financial crises is not evenly distributed. Many ordinary people lost their homes in the US, at devastating emotional and personal cost, while banking executives and bank shareholders were bailed out by the government. It would be interesting to know who paid the price of the fair value accounting scandal in China in 2001. Future research.

The information on fair value accounting in China comes from a paper I am working on with Stella Peng of York University and Kate Bewley of Ryerson University. You'll have to wait until it comes out in print before you can read it.

Photo of diving board in the Kawartha Lakes taken in 2016.

Photo of a fundraising standards certificate taken in Glasgow in 2012.

Photo of joint venture between architecture and religion taken in Stockholm in 2015.

Photo of the underlying conditions of a building in Kathmandu taken in 2014.

Photo of  a bank stuck holding a lot of empty boxes taken in Dhaka in 2014. These are the metal-lined boxes that money is shipped in, sitting on the loading dock behind the Central Bank of Bangladesh.

Brilliant Youtube video courtesy of Jonathan Jarvis at Crisisofcredit.com. I use this video in my classes and I think Jonathan has done a fantastic job of explaining the causes and consequences of a very complex crisis. Chapeaux!