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Fair Value Still Requires Judgment

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International Financial Reporting Standards 13 is effective as of the beginning of January. While hardly a cause for celebration, it's a good time to understand what IFRS is all about and why it requires judgment.

IFRS 13 is an international guideline for what many financial institutions have been doing for a long time. The main goal of IFRS 13 is to provide the framework for measuring "fair value."

What is fair value? It is a method to assess the value of a financial instrument based on the "exit price," which is defined as "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date." In other words, a financial asset value is not reported as the price where it was originally bought. Rather, it is reported as the price where it can be sold. (And vice versa for a liability.) Hence, the more common term of "mark-to-market."

IFRS 13 doesn't say what items should be or can be at fair value. (Other IFRS do that.) It tells you how to determine fair value. This is a concept first formalized under U.S. Generally Accepted Accounting Principles years ago.

Even with all the history around this process, it's rarely straightforward outside of highly standardized and highly liquid financial products. When it is not straightforward, it is often disputed on both the basis of the result and the process itself. Thus, judgment, which relies upon a deep knowledge of financial markets, plays a heavy role.

Marking to market is a topic that is slightly controversial because it makes the asset and liability values of financial institutions volatile. Thus, the share price of a financial institution as well as its capital requirements are a function of market prices which we know are never static.

However, while this causes some valid concerns, what is rarely discussed is how subjective the process of marking to market actually is. The fact is, a market value for a product which is not actually being transferred is merely theoretical and requires some rules around how it is determined. IFRS 13 doesn't go into this level of detail, but each financial institution which marks to market has an internal set of guidelines that answer questions like the following:

  • Do we use the bid or the offer?
  • What if the bids and offers are indicative only?
  • Do we use the last price traded?
  • What if the last price traded is old?
  • What if the last price traded or even the bids and offers are for a size significantly smaller than what we hold?

While there are internal guidelines at each institution for answering these and other questions, the answers are not straightforward for non-standard products which by definition are not liquid. This is where the judgment and knowledge of financial markets and what market prices really mean come into play.

One of the complications of using non-standard financial products is that the question of fair value is often answered by an individual who may be biased. More specifically, the trader or market-maker at the bank that created the product in the first place is often the person who is most capable to mark that non-standard financial product to market. While there are control functions at all financial institutions that are meant to verify the prices that traders give, it is often hard for those individuals working in control to have an adequate understanding of a market to even question the price. This is especially true in non-standard financial products.

The immediate response is often that we should either ban or regulate these "scary" products and make this "unacceptable" situation go away. Unfortunately that doesn't solve the problem for which non-standard financial products are often created in the first place. Many financial institutions have specific risks which need hedging and prefer to use tailored product that matches the risk it has. Thus, the compromise made is that they get the exact hedge they want but the valuation of it may not be as clean and clear as they would like.

Has IFRS 13 solved this problem then? No and it's not designed to because there is not a black and white answer to every accounting question. The real issue is whether firms are aware of how much judgment (often subjective) actually goes into their accounts.   

Terri Duhon, author of "How the Trading Floor Really Works", is a financial market expert with almost 18 years of experience in financial markets. She graduated from MIT in Math in 1994 and immediately joined JPMorgan as a derivatives trader on Wall Street.

 

 

 

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