Is Fair Value Accounting “fair”?

The press has been very vocal about the impact of fair value accounting also called
“mark-to-market accounting” following the global economic meltdown. Is fair value
accounting responsible? How could a reporting change affect the financial markets?
Is fair value accounting”a good thing”?

Not since current cost accounting was discussed in the 1970s has there been so
much written about a change in accounting standards. As we know, current cost
accounting did not succeed past the discussion stage in gaining acceptance. Fair
value accounting on the other hand has been implemented internationally. The US
has been the primary proponent of this change in accounting standards.

Fair value accounting was adopted in the US in 2006 following the financial
accounting standards Board's adoption of Financial Accounting Standard (FAS) 157.
Fair value accounting involves revaluing financial assets and liabilities to their
market values rather than retaining them in the balance sheet at historical cost. The
impact has been most widely felt in the banking and financial sector where balance
sheets contain assets not usually found in other industry sectors. These financial
assets can fluctuate wildly depending on the financial markets. The question arises
whether the standard should be applied to all assets and liabilities where market
volatility can affect the balance sheet fairly dramatically. As an accountant I feel
strongly about applying a standard in some instances and not in others.

Plantin, Sapraand Shin (2004) who examined the impact of mark to market
reporting developed the hypothesis that the longer the duration of an asset and
more illiquid the asset, the more vulnerable it is to artificial volatility. They
recommend only using mark to market reporting for short-lived assets. This would
be a difficult application of the standard and would leave management exposed to
the risk of purchasing an asset, describing it as a short-lived asset, reporting it to
shareholders as such and then due to market conditions not being able to dispose of
it. This would result in having to restate audited financial statements.

Banks and financial institutions have commented that fair value reporting has
introduced artificial volatility into financial statements and that fair value reporting
should not apply to financial instruments. For accountants it means that we would
be expected to interpret the standards to apply to the types of financial instruments
used in banking and financial sectors and possibly some other sectors. It would also
create difficulty in comparing corporation’s financial statements which is really the
basis of developing an international set of standards.

The actual reason for the crisis in the banking and financial sector is not reporting
standards but a failure of adequate credit analysis. Subprime mortgages were
extended to clients who could not possibly afford them. In this case mark to market
accounting accurately reported the true value of those assets in the bank's financial
statements.

The International Accounting Standards Board has been under pressure to change
the International Financial Reporting Standards to allow banks and financial
institutions to report certain assets at historical cost. While this issue hasn't been
resolved at the IASB they appear to be swayed by government influence and
intervention.
In Canada as we move to the implementation of IFRS in 2011 this issue will become
critically important. Our banks and financial institutions have not had the same
experience with the subprime mortgage assets that were prevalent in the US and
their exposure was limited. We would hope that the IASB heeds the advice of its
member bodies and maintains the original standard without succumbing to political
pressure to change the rules.