Fair-value accounting and the cubist art of Pablo Picasso have much in common.
Both are interpretations by the artist, based on easily understood ideas and transformed to the point where they sometimes become confusing and difficult for viewers to understand, and both have at best an artistic relationship to reality.
Of course, with fair-value accounting, the artist is responsible for creating the fair-value estimate, and the viewer or user is an auditor, investor, analyst, or the Securities and Exchange Commission.
The Financial Accounting Standards Board recently voted by a narrow margin not to require fair-value accounting for loan and lease losses, despite its staff's recommendations to the contrary.
The decision not to require additional fair value is a rare thing these days. It seems that every new accounting standard and interpretation is painted with a fair-value brush, requiring or forcing the need for fair value simply to resolve problems with the current standards, even though fair value, in and of itself, distorts the picture.
It also doesn't help that the SEC has been cheering on the board's fair-value work in past years, despite there being no evidence that fair value is a better measurement for evaluating financial performance and the certainty that it is a distortion of reality.
In deciding against requiring additional fair value, the FASB cited industry and regulator opposition to such dramatic changes to the current accounting model and the questionable value to users. On all of these counts, the board was absolutely right.
The banking industry is opposed to fair-value accounting in many aspects, because it distorts the traditional business of banking.
The regulators have resisted the fair-value movement with regards to loans, as well.
It is noteworthy that bank analysts and credit rating agencies, those who follow banks the closest and give the severest scrutiny to their financials, are not crying out for full fair value. This is because fair value all too often is subjective and cannot be used reliably as a base on which to analyze past or future performance, including cash flows.
That is not to say that analysts do not appreciate the presentation of fair value in footnotes.
But no one would rely upon Picasso's art to identify who his living, breathing models were. In our discussions with bank analysts, it has become clear that fair value is not their preferred model for presentation on the face of the financial statements.
Fair value can be used and enjoyed in certain circumstances, with due care. Any fair-value measurement is limited by the conditions prevailing on a given day and on the factors surrounding the calculation (whether there is a liquid market, the amount of time to sell, qualified buyers, etc.), and by the effectiveness of the model used to approximate market forces. (Fair value may or may not be market value.)
The limitations on fair value are mitigated when an asset or liability is managed on a fair-value basis and has a deep, liquid market from which to source more objective values.
In the case of banks, these limitations are mitigated enough to risk a reliance upon fair value generally only for regularly traded securities.
This is not to say that fair value is taking its dying breath at the FASB. To the contrary, because of board members' enthusiasm, there is an ongoing project to require fair-value accounting for all financial instruments, including loans and other instruments for which a market valuation is not readily available.
If the FASB is determined to move to full fair-value accounting, it's time we all focused more attention on whether the artistry of fair value makes an appropriate accounting model. We believe it does not.