More on Fair Value...

Today's FT has a piece by Anthony Rayman, who writes on Accountancy, about the perils of Fair Value. You can find it here.

Fundamentally, you can get the gist of what he is saying via the title: Bad Financial Practice Can't Exist Without Bad Theory.

And boy is he right.

Let's start here:

Traditional historical accounting is a wonderful system for counting beans.

Absolutely correct. The problem is that counting beans doesn't give you the real story: anyone who has ever had anything serious to do with a company's balance sheet, either in creating one or in analyzing one, needs to understand, fundamentally, that a balance sheet is the picture of the status of the company's financial standings at a set point in time. There's enormous problems with this: choosing a point in time right before deciding to write off investments, or right before deciding to invest heavily, or any one of a huge number of scenarios, can lead to a rather distorted picture of a company's relative success.

The accountants decided to try to change this, rather than trying to live with it and accept the fact that sometimes you need more than accountants to understand how a company is doing, or more exactly, you need hard work and significant talent to give you good analysis.

And this is, of course, also correct:

Because they routinely send such totally false signals, accounts prepared strictly in accordance with International Accounting Standards Board standards probably cause more economic damage than all the high-profile financial scandals put together.


But I'd expand on that point a tad further: it's not so much the accounts as much more the inability of analysts to do their jobs properly. Let me repeat at the risk of being boring: you need hard work and significant talent to give you good analysis of the future value of a company. This is not something that can be learned (the basics can be, but only experience is the true teacher), but rather takes time and costs money, something that the business is usually not prepared to pay. You used to be able to get the analysis you paid for: this industry was destroyed because it is damned hard to differentiate between pablum put out by a horde of 20-year olds under the control of an experience analyst and right and proper analysis prepared by someone who has 15 years' experience. The mass-production of such analysis put the careful analysts out of business, as they couldn't compete.

Instead of repairing this fundamental defect, "fair value" accounting - where some items are marked to the market price at which they could be sold or transferred - is liable to make matters worse. Since the mere presence of an item in a company's accounts is conclusive proof that its sale or transfer has not, in fact, taken place, a fair value represents the hypothetical proceeds of an imaginary transaction. This risks introducing further distortions.

The problem is not merely "further distortions" but procyclical distortions that make things vastly worse than the situation before such valuations.

The conventional academic wisdom that an increase in an asset's value necessarily represents a gain to its owners is a fallacy: it may actually make them worse off. Not only does fair-value accounting encourage even more exaggerated swings in the economic cycle, it might misreport actual losses as fair value gains and actual gains as fair-value losses.

There is no objection to the disclosure of fair values on company balance sheets (best practice under the historical system); but to incorporate them throughout the accounts produces a mishmash of actual transactions and hypothetical market values - sometimes unintelligible even to the company's own financial directors.

Since the reporting of changes in fair value as gains or losses in the profit and loss account can make a low investment return look better than a high one, fair value accounting is useless for comparisons of corporate performance. By promoting the fallacy that an increase in the value of an asset necessarily makes its owner better off, it has repercussions throughout the economy.

Put bluntly, the conventional academic wisdom here is an ass. Rayman's analysis is spot-on: there is no objection to the disclosure of fair value, but to incorporate them as profits and/or losses is sheer idiocy. It goes beyond that: it is criminal stupidity, because it creates losses and profits where there are none.

I can't underscore that enough: reporting profits and losses that do not really exist is, usually, a reason to jail an accountant for fraud. This is what makes these "reforms" so criminally stupid.

Let's take an example to show the stupidity of this "reform": suppose I buy a house, privately, with a mortgage of 80% of the value of the house. I make my 20% down payment, move in, and start writing those monthly checks to continue to live in the house.

But let's suppose that my loan is no longer based on my actual purchase price, but rather on the fair value of the house: after all, this does change over time, and may as well go up as down. The bank owns the house, and is interested in knowing the "fair value" of the property that it retains title to until the mortgage has been fully paid off.

The value of the house therefore changes everytime the house is given a new "fair value" and the amount remaining on my mortgage changes as well: either the number of payments increases, or the value per payment increases.

Would anyone ever buy a house?

Or, more importantly, why would a bank ever finance the purchase of a house?

If the fair value of its holdings increase, but the value of the mortgages that it holds don't, then the bank is worse off financially - the ratio of value at risk increases without the bank being able to increase risk premiums - than it would have been if it wasn't in that business.

...the only lasting cure for bad financial practice is the elimination of bad financial theory. Removal of the perverse incentives of the accounting system requires a clear distinction between what is fact and what is opinion. That would make possible a system for publishing the return on capital that companies are actually planning to deliver and for continuously monitoring progress towards the goal.

Irresponsible lending can be discouraged by making legal enforcement of loan contracts, particularly repossession of property, conditional on due diligence on the part of the lender. Faulty risk analysis can be corrected by the exposure of wishful thinking masquerading as mathematical rigour. But false accounting cannot be eradicated as long as the IASB insists on promoting as "fair value" a system that is, quite frankly, fraudulent.

Amen. The whole point of accounting is to remove opinion from facts: what has happened, instead, is that the accountants, after seeing how much money can be made with opinions, have decided that is the area where they want to be in business.

To the vast, vast detriment of their profession.