Transparency became a priority following all of the shenanigans that led to the financial crisis and the Great Recession. Banks drew fire because they used traditional accounting principles in order to downplay their huge losses from junk mortgages.
The banks valued their financial assets on their original costs. But that was problematic. The mortgages and securities backing the subprime borrowers were valueless. The banks were accused of disingenuous behavior — to say the least.
So reformers pushed for “fair-value” accounting for mortgages, bank balance sheets and many other types of assets such as patents.
In investing, the term fair value applies to an asset’s sales price over which a buyer and seller agree.
In accounting on a company’s financial statement, the term denotes the likely significance of assets and liabilities.
Fair-value accounting criticism
But in 2014, Charles Lee, a professor of accounting at Stanford Graduate School of Business, argued that fair-value accounting isn’t fair.
Dr. Lee asserted fair-value accounting is counter-productive because it promotes uncertainty in financial reporting and hurts shareholders.
Worse, he believes fair-value accounting makes it possible for banks to go back to their dubious practices.
In a Stanford University article, Charles Lee: Why Fair-Value Accounting Isn’t Fair, penned by Edmund L. Andrews, Dr. Lee argues the purpose of accounting is to provide an precise picture on transactions — to give tools to shareholders so that they can make their own forecasts.
However, market-value assessments are poles apart. In essence, they are forecasts containing the opinions of buyers, investors and sellers — about cash flow, growth and even the economic environment.
“The market has come to rely on accountants as the keepers of economic history,’’ states Dr. Lee.
“As an investor, when I turn to financial statements, I want a trustworthy and interpretable account of what took place,” he explains. “As soon as we start to anticipate future exchanges, we are in a world of speculation. And unfortunately, given dysfunctional managerial incentives and other moral hazard problems, it is often a world of fiction.”
“As an investor, when I turn to financial statements, I want a trustworthy and interpretable account of what took place.”
He maintains current market values are less accurate in situations like the mortgage debacle in the Great Recession. Everyone is terrorized and reluctant to buy stocks.
“The mortgage crisis was a very unusual situation, because the market had frozen up entirely,” said Dr. Lee.
“Under those types of settings it is very difficult to know what the fair market value of something should be,” he added. “The idea of fair-value accounting is that you’re marking your asset to the price it would receive in the marketplace in a fair and orderly liquidation. But what does that mean if every bank in the market wants to sell?
“Fair-value accounting has this wonderful seductive appeal, because that’s what the world thinks an asset is worth,’’ he continued. “People think market value is Truth with a Capital T. But it’s not.”
Mr. Andrews’ article also recalled how the Enron scandal evolved:
Indeed, there is at least one notorious case in which fair-value accounting was used as a tool of corporate fraud: the collapse of Enron Corp. Top executives at the energy-trading giant insisted on using fair-value accounting to artificially inflate the value of many of its energy-delivery contracts. The maneuvers have been detailed in books (see Power Failure: The Inside Story of the Enron Collapse) as well as in scholarly papers. Over the objections of Sherron Watkins, an Enron finance executive who later became a key whistleblower, the company used what is known as a “Level 3” approach to fair-value accounting. “Level 3” is a set of principles for determining the “market’’ value of assets in which there is no trading and hence no market. The company relies instead on internal assumptions to estimate what prices would have been if there had been a market.
Dr. Lee doesn’t argue fair-value accounting is dishonest.
“I think that many of my colleagues who support fair value sincerely believe they are taking the high road,’’ he said.
However, like the Enron affair, he’s quick to point 0ut fair-value accounting can be exploited.
“Accounting provides investors with a language and tools to make their own forecasts of future earnings growth,” Lee says. “Most of the fair-value stuff isn’t going to help them. In fact, it’s going to screw them up.”
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“Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings.”