Bankers have long worried that accounting standard setters are conspiring to phase out conventional balance-sheet measurements in favor of a method that bankers argue is volatile and unreliable, but their objections are no longer unqualified as the method seeps into industry balance sheets.
Increasingly, bankers are concluding that conventional valuation methods cannot keep up with the innovative capital-markets instruments that banks consume and manufacture. The method they claim is being forced upon them does in fact provide relief from some nasty accounting problems, and it frequently allows better matching of accounting and economics.
It could also simplify hedge accounting, and given the legion of financial companies that have tripped on accounting standards for derivatives, the promise of simplicity is seductive.
So when the Financial Accounting Standards Board convened a public roundtable last week to get feedback about its project on the method, known as the fair-value option, bankers were well represented. Fair value is by no means a new concept, but its applicability is increasingly crowding out the historical-cost method - banks' traditional valuation method, which is about as old as its name implies.
The board's mission to make financial statements more valuable is maddeningly complicated by the array of constituencies that use them. Companies, investors, and regulators each have different purposes for financial data, and the search for an elusive combination that appeals to all groups inevitably seems to disappoint everyone.
"Historical cost is not a great solution; fair value is not a great solution - neither is perfect, and neither is extremely useful in the absence of much more information," said Neri Bukspan, a managing director and chief accountant at Standard & Poor's Corp. "The current system is not optimal, and the solution is not optimal."
There are two standards under development that are generally perceived as the most recent mileposts on the long road to a brave new fair-value world. FASB proposed the first, "Fair Value Measurements," in June 2004 as general guidance on, not surprisingly, how to measure fair value for all current and future standards in which the method is required. Its adoption has been delayed by a rigorous debate on appropriate valuation methods.
The fair-value option issued in January is the second. It garnered 80 comments - not an insignificant number for accounting proposals, whose appeal tends to be limited to a decidedly esoteric audience. Banks, investment banks, and insurance companies, along with their auditors, dominated the roster of commenters.
The "option" element of the fair-value option is twofold. Companies can elect, but are not required, to adopt the method; and they have the option of deciding which assets, liabilities, financial instruments, and contracts to value under the method. When companies originate or purchase an item, they must make an irrevocable decision on how to value it.
Though the measurement and option projects have ostensibly evolved independently, they are closely intertwined.
"The fair-value measurement project tells you how to determine fair value; the fair-value option project tells you when we are giving you a choice to choose to use fair value rather than the other currently required measurement of a financial asset or liability," said Robert Wilkins, who is managing the option project for the standards board. "It's when to, versus how to, do it."
Despite their occasionally combative relationship, accounting is frequently an area of comity for bankers and their regulators, and FASB's fair-value option is no exception. Both have grave doubts about measuring fair value reliably.
Though the terms "fair value" and "market value" are frequently used interchangeably, market value is more accurately a subset of fair value. The price at which assets in a liquid market swap hands between willing parties - market value - is a good approximation of fair value. Prices for stocks, bonds, and common derivative instruments like interest rate swaps are readily obtainable, so there is little squabbling about their fair value.
But as instruments become more individualized, arcane, and illiquid, there's no market to provide values. The value of residual interests in securitizations, structured products, and tailored derivatives, for instance, tends to be subjective - it is, with some limitations, whatever the company's internal model says it is.
"Our concern is the valuation and the adequacies of those models and the numbers that come out of them," said Zane Blackburn, the chief accountant at the Office of the Comptroller of the Currency. "We have had enough experience with modeling to know that you can make all kinds of different assumptions and come up with some very different fair values based upon those assumptions."
Regulators are not the only ones concerned about the reliability of fair value.
"Mark to market is an interesting and meaningful analysis, but … when you are really using a model with very questionable assumptions, it makes it difficult to get meaning out of that," said Frederick Cannon, an analyst with Keefe, Bruyette & Woods Inc.
Those concerns are amplified by the option element of the standard. A company could use fair value for one asset and historical cost for a substantially similar one. Another company could come to a different decision about which method to use. And even if both companies use fair value for the same asset, the value could fluctuate substantially according to the model and its inputs.
The option proposal "has the potential to hinder comparability among financial statements of institutions that we rate," Mr. Bukspan said. "We are quite concerned that from an analyst's perspective, it could be an analytical nightmare to try and figure out who is choosing what and why."
An element in the proposed standard known as "own creditworthiness" is equally as troubling to regulators.
A bank holding company that applied fair value to debt held by investors could find itself in an unusual position if its creditworthiness slips. The debt's market value would fall in relation to the credit erosion; the associated value of its balance-sheet liabilities also would fall. For instance, debt with a contractual value of $1,000 might be valued by the market at $800. Under the fair-value option, that $200 reduction would become income for the bank - and an equivalent increase in capital.
"It's counterintuitive to say that you ought to be recognizing income when your business is going to pot," Mr. Blackburn said.
Regulators are allied in their opposition to this odd ramification of the fair-value option.
"How realizable is that gain - if you will - on this type of a financial liability?" asked Robert Storch, the chief accountant at the Federal Deposit Insurance Corp. "The issuer is still contractually liable for the full amount of the obligation."
David Morris, a consultant to financial companies and a former financial director at JPMorgan Chase Bank, said fair-value accounting more closely mirrors the economics of financial instruments.
"If you are going to allow a fair-value option for assets and liabilities, then you should consider all of the inputs that go into determining fair value," he said. "I don't think it makes sense to say you are marking assets to true fair value, but the other side is adjusted for only some factors. If you are going to give people this election or option, then you should do it correctly. Fair value is fair value."
The standards board is considering regulators' objections to the current draft and expects to issue a final version this year. If it does not address regulators' concerns about the own-creditworthiness element, they have other options.
"If the final standard is like the proposal and own-credit-risk measurements are part of the fair value of liabilities to which the options apply and are part of capital, then the agencies could advise institutions to adjust regulatory capital for the amount of the fair-value gains and losses attributable to the gains and losses in own creditworthiness," Mr. Storch said.
Using the fair-value method also would have a profound effect on loan-loss reserves, which have long been a touchstone for controversy in the industry. Banks would not reserve for loans accounted for under the fair-value method.
"The income statement will reflect not the traditional provisions, but rather will reflect the change in fair value of your loan portfolio period over the period," Mr. Bukspan said. "Changes could be associated with numerous things: the fair value of the collateral, the creditworthiness of the borrower, or interest rates, for instance."
That introduces volatility - which is not something banks, their investors, or regulators welcome.
"By moving to fair-value accounting, you get numbers moving through income statements that completely distort the ongoing business activities of the firm," Mr. Cannon said.
He offered mortgage servicing rights as a case in point. "If the value of that asset moves by 1% or 2%, it can really jerk your income statement around - and that relatively modest move in the value of the asset is really not a reflection of what the ongoing income of the company is," he said.
For all the limitations banks claim, fair value is more relevant for a growing number of financial instruments. Banks may find it of limited use for conventional loan portfolios, but it more accurately captures the value of trading assets.
"Some people look at their financial instruments on a fair-value basis and run their business that way; some people do not," Mr. Morris said. "It depends on how you are viewing that business, which I think is the right way to go. That optionality allows you to mirror the economics, or the way you think about that business."
That's one of the reasons that, outside of their specific objections, regulators generally supported the fair-value option in an April 14 joint comment letter to the standards board.
"We didn't oppose fair value as an accounting standard - we just raised concerns about its application," Mr. Storch said. "We do see benefits where there are reliable fair values and allowing the use of the option would improve the financial reporting of the entity."
Companies already use fair value for derivatives and have the option to apply it for mortgage servicing rights and derivatives with embedded options, which in the past had to be bifurcated and accounted for separately.
But the proposal would greatly simplify hedge accounting by providing a method to bypass FASB's controversial derivatives standard, FAS 133. That standard allows companies to report hedged assets at fair value along with their hedges - as long as they can document reliably that the hedges were effective.
The standard has been a practice nightmare, as a large number of related, costly restatements have proven.
The fair-value option would "allow institutions to bypass all those requirements and just mark the derivative, which is required by 133, and the instrument it is hedging to fair value and eliminate all that complexity," Mr. Morris said. "That is probably the biggest reason why a lot of people supported this standard - to not have to worry about the FAS 133 hedging requirements."
Regulators also see the value.
"We all know that hedge accounting can be risky," and that "it is very complicated," Mr. Blackburn said. The fair-value option "gives you an alternative to using hedge accounting for certain types of instruments, and from that perspective, we are very supportive of having that option."
How the objections and the advantages will shake out is far from certain. The board has delayed the effective date of its fair-value measurements project until 2008. Mr. Wilkins said he sees the logic in pairing the releases of the option and measurement projects, but he could not guarantee that the board would make that choice.
But their adoption in one form or another seems inevitable. The International Accounting Standards Board already has an operable fair-value option, and FASB has committed to "convergence" with IASB.
"This is going to continue," Mr. Blackburn said. "FASB has made it clear they want to ultimately have all financial instruments at fair value."
But Mr. Wilkins said board members "haven't decided that a non-fair-value measurement is not appropriate ever, or otherwise they would be mandating fair value - they wouldn't be simply giving you a choice."
