Fair Value Accounting – Political Economy Hot Potato (Part 1)

7/15/2015 - Monocle Research Department

June 2011 marked the deadline by which the International Accounting Standards Board (IASB) and Financial Accounting Standards Board (FASB) were to have achieved convergence in respect of the new IFRS 9 reporting standard for financial instruments. IFRS 9 has been a phased project to replace the existing standard on financial instruments, IAS 39 Financial Instruments: Recognition and Measurement, at the behest of the Group of Twenty (G20), the Financial Stability Board, and others. Much has been achieved in a short period of time, although the IASB and FASB have announced a postponement of convergence in respect of revenue recognition, lease accounting, insurance contracts, and which financial instruments to hold at fair value. Notwithstanding the June deadline having been extended by a couple of months, the sense of urgency with which this ambitious project was undertaken is indicative of the severe shortcomings and inconsistencies evidenced by the existing standards in the teeth of the financial crisis.  

Equity, debt, and derivative securities valuations tumbled vertiginously during the eye of the storm, most notably in respect of marked-to-model structured finance positions such as CDOs, whose values collapsed completely in the absence of liquidity. Predictably, attention once again focused on the controversy as to whether financial instruments should be carried at fair value on the books of financial institutions. Far from being a purely academic debate within the rarefied confines of the accounting standard setters and regulatory bodies, the actual life or death of many financial institutions hinged on the interpretation of this question.  

Bankers seethed with rage at having to carry trading instruments at mark-to-market or mark-to-model fair values; it was argued that fair values at that time did not approximate anything like the intrinsic worth of assets, with the result that reported losses at the height of the crisis, and insolvency of certain institutions, were thus temporary and illusory. Monolines such as MBIA and AMBAC, forced to write off most of their book equity under fair value accounting, argued that actual cash impairment was a fraction of reported non-cash losses, which would likely be reversed in future periods. One could argue of course that this would be a natural reaction of firms that were about to fail. The fact of the matter is that the banks and monolines were incorrect to a large degree about the value of their assets. Many banking institutions required recapitalisation, MBIA continues to have a speculative grade credit rating from Moody’s, and AMBAC filed for bankruptcy in 2010.  

Given the implications for financial stability, the suddenness and severity of write-downs shifted the fair value debate from academia to the banking world, and thence to the political sphere. Clutching at straws, politicians in the US, UK, and Europe turned on fair value and mark-to-market accounting as complicit in the collapse of the banking system, or worse, the root cause of collapse. Both Republicans in the US and EU president Jose Manuel Barroso called for its suspension, Hank Paulson reiterated the right to suspend fair value accounting in his rescue bill for the US economy, and French president Nicholas Sarkozy and his finance minister Christine Lagarde demanded its overhaul. Many politicians became convinced that in killing mark-to-market accounting lay part of the answer to the financial crisis.  

These knee-jerk reactions echo earlier watersheds in the history of fair value accounting. The banking crisis attendant on the Great Depression occasioned similar political hand-wringing at the time. US Comptroller of the Currency Preston Delano declared in the July 1938 Federal Reserve Bulletin that “...the soundness of the banking system depends upon the soundness of the country’s business and industrial enterprises, and should not be measured by the precarious yardstick of current market quotations which often reflect speculative and not true appraisals of intrinsic worth”.  

In fact, the fair value debate has followed the Great Depression banking crisis, the Savings and Loans banking crisis, and more recently the Great Recession banking crisis. Banking as an industry requires accurate and uncontentious accounting measures to represent the values of assets and liabilities. Going back to the very beginning, it is perhaps no coincidence that modern accounting and modern banking emerged at around the same time in the Italian city states of Genoa, Venice, and Florence. Merchant banks were necessary to service the rapidly expanding commercial and trade interests of these centres, in turn necessitating the invention of double-entry bookkeeping to record the numerous transactions, keep track of debtors and creditors, and facilitate efficient management.  

The man credited with inventing double-entry bookkeeping, Luca Pacioli, was a Franciscan monk, tutor, and mathematician, among whose many achievements is said to have been teaching Leonardo DaVinci mathematics. From those beginnings in the 14th century, double-entry spread across Europe during the Middle Ages. It had already reached Germany by the 15th century, Spain and England in the 16th century, and Scotland in the 17th century. By the late 18th century, Goethe has one of his characters in Wilhelm Meisters Lehrjahre (1796) call double-entry "among the finest inventions of the human mind." Double-entry provided a rational way of drawing up accounts through the calculation of assets and liabilities and the determination of profits and losses. It proved a durable and robust technique for drawing up accounts because each transaction was recorded twice, once as a debit and once as a credit, which were then cross-indexed to corresponding accounts in a ledger, and finally balanced.  

It’s interesting to note that among several works on mathematics that Pacioli published, his Summa de Arithmetica in 1494 summarised all knowledge in mathematics at that time. In this book Pacioli presented a puzzle which became the seed for all later developments in estimating probabilities and making predictions, but not before confounding mathematicians for almost two centuries. Pacioli challenged readers to determine the fairest way of splitting a pot between two gamblers, who are interrupted during a best of five dice game, when one of them is two games to one ahead.  

It was only in the early 16th century that Girolamo Cardano managed to estimate the probability of rolling a specific number on a dice (1/6) and rolling the same number on a dice consecutively (1/36). And it was not until 1654 that the Pacioli puzzle was finally solved through a famous correspondence between Blaise Pascal and Pierre de Fermat. They determined that the gambler who was ahead would clinch the game three times out of four if the game were completed. In solving this puzzle Pascal and Fermat established the foundations of probabilities, which would later develop into the science of statistics through the work of Bernoulli, de Moivre, Gauss, and others.  

That Paccioli should be acclaimed on two such distinct counts, both as the progenitor of double-entry bookkeeping, and of germinating the idea that led to probability theory, which today underlines forward looking statistical views of financial markets, may certainly be regarded as a kind of situational or historic irony. From this distant common origin the practice of these disciplines diverged markedly, but have now reconverged, in the sense that accounting regulations are now predicated on the ability to predict into the future, implying the application of statistics, as opposed to an IAS 39 world in which accounting numbers represented a snapshot of the immediate past.  

This shift signals a profound sea-change in the manner in which financial instruments are accounted for. Previous historical episodes have seemed to consist of a fairly predictable cycle through which fair value would at first become lauded on the rising tide of buoyant markets, its value questioned as the uncertainty of stormy seas set in, and finally abandoned.  

The recent impetus for a shift in the underlying philosophy of accounting for financial instruments is to meet the needs of the financial markets, and the demands by regulators and the G20, for a standard that is less volatile and less procyclical. The accounting standard setters have responded with a prompt overhaul, which is sensible rather than radical.

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