Why fair value is vilified

David L. Larsen of Duff & Phelps examines the possible causes for fair value's pariah status in the private equity world. An excerpt from PEI Media's forthcoming book: The Definitive Guide to Private Equity Valuation

David Larsen

Why do so many intelligent, articulate people seem to believe ‘fair value’ is problematic? While there are numerous opinions behind the denigration of fair value accounting, in general there are five specific reasons that have caused a venomous reaction to fair value principles: the bursting of the real estate bubble, the conflict between rules and principles resulting in the misapplication of mark-to-market accounting, increasingly illiquid markets for certain assets, the impact on banks of ‘other than temporary impairment’ accounting rules, and regulatory reliance on GAAP financial statements.

1. Bursting of the real estate bubble
First and foremost it must be acknowledged that the real estate bubble did in fact burst. As the value of real estate started to decrease in 2006, other dominoes started to tumble. Credit markets started to seize up, assets originally deemed liquid became illiquid and off-balance sheet risks became more apparent.

Mark-to-market accounting did not cause homeowners to stop paying their mortgages. Mark-to-market accounting rules did, however, force financial statement preparers to more robustly evaluate the value of those assets which were required to be recorded at fair value. Because fair value accounting shines a brighter light on management’s assessment of value, many started to shout ‘get that light out of my eyes’. While the longstanding rules of recording certain assets at fair value were well understood, the greater focus on transparency adopted by FASB ASC 820 accompanied with the deflation of the real estate bubble caused a reaction that negatively characterized FASB ASC 820 as the villain.

2. Conflict between rules and principles
The second major problem came as the result of the confluence of two independent, unrelated noble goals. The first was the issuance of FASB ASC 820’s predecessor SFAS 157 in the US combined with FASB’s stated goal to establish accounting standards that are more principles based (similar to international accounting standards). One of the past criticisms of US GAAP was that it was deemed very rules based. With potential convergence between international accounting standards and US GAAP, FASB is making a concerted effort to provide accounting standards that are principles based. Therefore, SFAS 157 was issued in 2006 and recodified as FASB ASC 820 in July 2009, to provide guiding principles requiring the exercise of judgment. It did not provide specific rules.

The second noble goal was to ‘fix’ corporate fraud and the audit profession, post-Enron, post-Parmalat. The Sarbanes-Oxley Act in the US created the Public Company Accounting Oversight Board (PCAOB) as the regulator of auditors. The PCAOB’s reach extends around the globe to auditors outside the US. Sarbanes-Oxley also created criminal penalties for CEOs, CFOs and auditors who ‘broke the rules’. Therefore, more than ever in the current economic crisis, management and auditors want to follow the rules. Yet principle-based accounting standards require the exercise of informed judgment. At the time of writing, the PCAOB has been silent in providing guidance to auditors on what rules should be followed when auditing judgmentally-determined fair value estimates. The historical rules-based system has crashed head-on with a newer principle-based accounting standard.

One of the ways many have dealt with this problem of rules versus principles is to focus on observable transaction prices, even in markets which have become inactive or where the volume of transactions is low. Using observable transaction prices is deemed to provide stronger evidence that one is ‘following the rules’. This is the primary catalyst providing fuel to those who believe mark to market requires ‘fire-sale’ pricing. If an asset is sold at a distressed price – a fire-sale price – and if management and auditors use that reference price as a basis to value other assets, effectively everything is valued using the last observable transaction price or fire-sale price. Accounting rules do not require the use of last transaction pricing, but some have adopted that practice to ensure that they don’t ‘break the rules’!

FASB has twice amended SFAS 157, first in October 2008 and again in April 2009; the IASB released an expert panel paper in October 2008. These developments have the primary goal of pushing financial statement preparers and auditors to use judgment to estimate fair value while taking into account all appropriate inputs, especially in markets that are not active. Even with these amendments, tension continues to exist between the rules-based regulatory environment and the new requirement to use informed judgment in estimating fair value in the current environment. This tension is often eased when a third-party valuation expert is brought in to assist the validation of such informed judgments. However, tension will continue to exist where management teams are not robust in the use of appropriate inputs or in the documentation of processes, procedures and conclusions.

3. Growing illiquidity
The third reason for the violent reaction to mark-to-market accounting was the increasing illiquidity in certain markets. Many assets, including structured products, asset-backed securities and related financial instruments, were initially valued using Level 2 inputs (prices were observable or were based on similar securities in active markets). As fewer and fewer transactions took place, FASB ASC 820 (as amended) required that additional inputs (Level 3) be used to estimate fair value. However, because of the stigma associated with Level 3 inputs (deemed toxic), and management’s and auditor’s reluctance to move away from observable (Level 2) pricing, these illiquid assets increasingly are valued at last-transaction prices. Again, this is not because it is required by FASB ASC 820, but because there is a level of comfort in using observable inputs.

4. Hold-to-maturity loans
The fourth enemy of mark-to-market accounting is not really fair value itself, but the impact of other accounting standards applicable primarily to banks. When a hold-to-maturity loan is deemed other than temporarily impaired (it is beyond the scope of this guide to discuss the nuances of hold-to-maturity accounting), the loan needs to be written down to its fair value.

First and foremost, it must be stated that such write-downs are precipitated by a triggering event identifying that the loan is in fact impaired. Then, and only then, does mark to market apply. After several months of consideration, in April 2009, FASB issued new rules for ‘hold-to-maturity loans’ which provided investors with greater transparency by recording the ‘credit component’ (actual expected cash loses) of the fair value adjustment in the profit and loss statement (impacting regulatory capital) and the remainder of the fair value adjustment (due to market conditions, marketability and supply/demand) as a reduction in ‘other comprehensive income’ (a separate component of equity which does not impact regulatory capital).

5. Prudential regulation
And finally, the fifth point is related to prudential regulation. Repeatedly we hear shouts that mark to market is preventing banks from lending. How could an accounting standard handcuff lending? Prudential regulators, not accounting standard setters, determine how much a bank can loan based on various criteria, including a bank’s capital adequacy. When loans are impaired and are written down to fair value, a bank’s capital is reduced and the amount a bank can loan is reduced. Bank regulators do have the ability to determine both the amount of capital required and where adjustments to the calculation of capital are necessary. Therefore, regulators can allow adjustments to the financial statements in determining capital adequacy.

This passage is excerpted from The Definitive Guide to Private Equity Valuation: An in-depth A-Z guide to valuing investments fairly, a new book from PEI Media. Primarily written by valuation experts Duff & Phelps LLC, this guide provides investors and fund managers with valuable tools and practical guides to fairly value nuances and scenarios, as well as case studies and best practices. Sample contents and more information on the book are available at www.peimedia.com/pevaluation.