As soon as major western banks showed MTM losses, the standards for fair value accounting were eased.
Participants in the “mature” financial markets in the west have for decades lectured the developing world about the contrast between their transparent financial accounting and the “unreliable” accounts produced by our companies. One of the principles emphasised on fair value accounting. Interestingly, as soon as major western banks started reporting huge losses from the mark-to-market values of credit derivatives held in the trading portfolio, the Securities and Exchange Commission (SEC), acting jointly with the US Financial Accounting Standard Board (FASB), relaxed the prescriptions on the calculation of fair values!
The International Accounting Standard 39 defines fair value as “the amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length transaction.” Fair values are measured in three ways:
Level 1: Quoted prices in active markets for the same instrument
Level 2: Quoted prices in active markets for similar assets or liabilities or other valuation techniques for which all significant inputs are based on observable market data.
Level 3: Valuation techniques for which any significant input is not based on observable market data.
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In a clarification issued on September 30, the SEC says that “in some cases using unobservable inputs (level 3) might be more appropriate than using observable inputs (level 2)” and “the determination of fair value often requires significant judgment”. In effect, to my mind, the SEC has given its blessings to the type of accounting used by Enron. So much for the sanctity of fair values!
But this apart, the MTM losses in the banking system have led to a media debate about the whole conceptual underpinning of fair value accounting. (I had referred to some of the issues in an article titled “The Unfairness of Fair Values”, May 17, 2004.) Now that we are going to follow the International Financial Reporting Standards (IFRS), and so many Indian companies are reporting MTM losses on their hedges, the major conceptual weaknesses need to be clearly understood by those concerned with financial statements of the corporate world.
One weakness is that the fair value accounting of derivatives hedging “unrecognised firm commitments” — for example, a pending import or export order denominated in foreign currency — can affect the reported profit. MTM accounting only of hedges, and not of the underlying, distorts the reported profit, vitiating to an extent the “true and fair” nature of the accounts. This practice also militates against the basic accounting principle of “matching” revenues and costs of specific transactions in the same accounting period.
Consider a company which has only one receipt of $1 million due on, say, September 30. In April, the company sells the dollars forward at say Rs 42. While preparing the accounts for June, the forward contract needs to be marked-to-market at say Rs 48, since the rupee has depreciated. The MTM loss of
Rs 6 million will now be reflected in the June accounts. On September 30, the dollars are duly received and are delivered to the bank under the forward contract at Rs 42. The MTM provision of Rs 6 million will now be reversed and reflected in the September accounts. Thus the results of both quarters are affected by the MTM accounting: adversely in the June quarter, beneficially in the September quarter, in violation of the “matching” principle referred to above. One way out is to treat even hedges of firm commitments as being of “highly probable forecast transactions”, or as cash flow hedges, for accounting purposes: in that case, the impact of MTM goes to equity and does not distort the reported profit.
The same principle of matching revenue and expenditure gets violated in fair value accounting of debt securities. Consider a fixed interest security. Its market value falls if interest rates go up, reflecting the opportunity loss on future cash flows from the investment — but the loss gets recognised upfront, well before the income accrues.
Another criticism of fair value accounting is that it departs from another basic accounting principle — namely the concept of “going concern accounting”: fair values give a break-up valuation, and not on a going-concern basis.
In principle, while everybody accepts that the accounting standard should not become a disincentive to optimum risk management, in fact it has become so — an example of the tail wagging the dog. There are worries that this could lead to a weaker risk management culture: in a survey, many companies in the global market have claimed that fair value accounting has had a major impact on their risk management/treasury policies, sometimes actually leading to increasing risks! Again, the accounting standard does not allow the users of the financial statements to clearly differentiate between derivatives used to reduce risks (i.e. hedges) and those aimed at adding to the bottom line by deliberately increasing risks. Given the large amount of losses sustained by many companies pursuing the second objective, this criticism has a lot of merit.
There are other, more technical issues as well. But IFRS is a fact of life and the corporate and banking world will have to live with it, whatever the conceptual weaknesses.