H. David Sherman, a Northeastern University accounting professor who wrote a book on fair-value accounting published earlier this year, is already at work on an expanded edition. He has much to expand on, given all the pronouncements, proposals and debates on the fair-value issue that have cropped up in recent months.
Sherman spoke with American Banker about the theory behind fair value, also known as mark-to-market accounting, and discussed the implications of actions taken by the Financial Accounting Standards Board, which is pushing for broader use of fair value in response to investors who want a clearer picture of what is sitting on companies' books. The FASB is examining whether it would make sense to bring all loans and deposits under the fair-value umbrella, even if banks have no intention of selling them.
It is also considering a rule that would require companies to provide a range of possible values, rather than a single estimate, for so-called Level 3 assets, which are the hardest to value and for which no observable market exists.
"The Fair Value Answer Book," an updated version of Sherman's 2009 "FAS 157 Answer Book," will be published by CCH Inc. in early 2010. The following is a condensed version of his interview with American Banker.
Of all the recent changes or proposed changes to the fair-value rules, which are most radical in terms of altering the landscape for preparers and users of financial statements?
SHERMAN: Radical accounting is an oxymoron. But if there was something radical, it was the revision the FASB made in April, where they said you could take the change in value and separate the part that's due to credit risk from the part that's due to inactivity in the market — and the part that's due to the market you don't have to put through to income.
Also, the fair-value hierarchy with Level 1, 2 and 3 assets and liabilities — this is really a remarkable development. It's accounting, but it also is a broad business issue now in terms of what the implications are. People say things like, "From now on we're only going to take Level 1 as collateral." Investors, lenders and security analysts are making business decisions using this new vocabulary.
Which aspects of fair value have been most damaging to banks?
The real damage to banks occurred when they had certain investments or commitments that were risky and that ended up working out very poorly. Disclosing it is just really telling the world exactly what happened.
But fair value is a costly compliance issue. Where it also could be costly is if you misinterpreted the standard to mean that you really have to use the most recent market price, even if the market price was less than fair value because the market was inactive or because there were distressed sales. Investors and lenders do discount Level 3 valuations to some extent, so there is a natural preference to try to avoid Level 3. That could have been damaging in that there might have been excess pressure to try to go with Level 2 valuations, which would have been lower than using Level 3. But if a market's not active, then you really shouldn't use those Level 2 values. The fair-value accounting standard indicated this from the outset.
The recent proposal that would require banks to disclose a range of Level 3 fair values highlights the idea that all of these numbers are theoretical, to some extent. Does that generate a credibility problem?
Fair-value estimates for Level 3 assets or liabilities are really just estimates. Everyone who understands accounting knows there is really a range. It's like earnings per share, which is never really a single number. It reflects a series of judgments: Will the customer pay? Will a patent really be worth it? Will a drug really have a five-year life? How long will an airplane last? Nobody really knows for sure, and with banks it's the same thing. You're basing values on assumptions about the future. So I think showing a range actually adds credibility.
The FASB is trying to decide whether deposits should be marked to market, as well. Is that feasible? Is it useful?
When banks acquire other banks, they obviously have to assign some fair value to the demand deposits. So it is feasible. The question is, is it worth it? To me, this is all embedded in a much bigger issue, which is that of hedge accounting for derivatives. When the FASB was trying to solve that, I think they just put it aside by saying they'll solve it by having more assets and liabilities at fair value — because if you buy a derivative to hedge an asset or liability and both are at fair value, hedge accounting becomes unnecessary because it's almost always an automatic match.
Why does it make sense for banks to use fair value?
Fair value makes sense for any business because it is more relevant than historical costs, the most common alternative. However, when I see a loan balance and a related loan-loss reserve, knowing the process that banks and their auditors go through, I like that number. I know it doesn't take interest rates into account [as a fair-value measurement would], but I like the number because it tells me how much cash they think they are likely to receive.
If a bank owns its headquarters building, knowing what the value of the building is today is more relevant than knowing what they paid for it 40 years ago and watching them depreciate it down to zero. But if fair value is more relevant than historical cost, we also need to ask: can you get a reliable number? And if you can get a reliable number, but it's so costly to estimate that number, and if the number is out of date on the next day, is it worth it to require fair-value accounting for specific assets and liabilities?
Would fair value be such a hot-button topic if the financial crisis hadn't occurred?
Very simply, no. Before the crisis, if you were a bank that mostly had investments in active markets…you just used the market price as the fair value and there wasn't much to argue about. But then the financial crisis froze some of the markets, and you had fire sales or distressed-sale prices in others. That's what caused these huge reported losses. There was real decline in value, too, in things like mortgage-backed securities and collateralized debt obligations, because there were defaults.
