‘Is it fair to blame Fair Value Accounting for the financial crisis?’ by Robert C Pozen, Harvard Business Review, November 2009

A review of this article is included for our many contacts from the finance function, though it will hopefully be of general interest to all. However it is suggested that the full reading of the article should be confined to those with good accounting knowledge and an understanding of the issues involved. Though it is well written and simplifies as much as possible, there are some topics where even the best explanation is too complex for the lay person.

The question in the article’s title seems too obvious to require anything other than a quick ‘no’ but apparently serious commentators - including Steve Forbes, a high profile media figure and former US presidential candidate - have been putting forward this view. The authors reject the suggestion but, in their closing arguments, do concede that it has been a factor in reducing the stability of the banking system.

The basic question is not new and has been a subject of dispute in accounting circles since the 1970s when high inflation caused people to question conventional accounting reporting. Do you value assets at what you paid for them (historical cost) or what they are now worth? And if the latter, how do you value them? And does this apply to both assets that have gone up in value and those that have gone down?

Enron was an example of a company that moved away from historical cost methods and developed their own highly dubious ‘mark to market’ system which was used to produce imaginary profits and fraudulent results. This encouraged people like me to criticise the use of non-historical valuations and to recommend going back to good old conservative accounting methods.

However it was in an attempt to be conservative that the accounting authorities insisted on ‘mark to market’ methods for assets that have gone down in value and this is where the blame for the financial crisis has arisen. Should banks have to show investment assets at their current, maybe temporary, lower values and charge these losses in their accounting statements when they intend to hold such assets and in all probability, their value will recover? Isn’t showing such ‘theoretical’ losses only likely to increase the lack of confidence and create a downward spiral to bankruptcy?

There is not time to go into the detail of the highly complex arguments around different types of assets and valuation methods but it is worth mentioning the author’s rather elegant solution, similar to one that I have been advocating since the days of inflation accounting. If you want to show shareholders the impact of increased or reduced asset valuations, this can easily be produced as a separate statement apart from the main set of accounts. This separate statement can include all the information about methods, assumptions and reservations that inevitably accompany asset valuations and are necessary to fully understand them.

It may cause distrust to have two sets of books but that is better than pretending that one set of accounting statements can tell you everything. But such a solution is far too simple and logical for the accounting bodies of the world to accept so the debates and the misunderstandings will go on. And shareholders will become increasingly sceptical and confused about the results they are seeing.

To read this article go to

http://hbr.harvardbusiness.org/2009/11/is-it-fair-to-blame-fair-value-accounting-for-the-financial-crisis/ar/1