As part of our matrix accounting series we begin our coverage on the most controversial topic of 2008 - Fair value accounting. With Indian GAAP set to embark on this new accounting standard from next year, we bring to you some of the interesting facets of fair value accounting for financial instruments.
The co-incidence couldn't have been worse for the banking sector, FASB's re-loaded version of fair value accounting FAS 107 in the avtaar of FAS 157, times itself with one of the biggest credit crunches in recent times.
The GAAP's (FAS 157) intent was to provide investors with added transparency by forcing companies to mark to market assets and liabilities. On the contrary, many pundits feel that fair value accounting does the exact opposite. Instead of providing investors with a better picture of economic reality, fair-value accounting distorts market realities by leaving too much room for management's discretion and potential abuse.
So does FAS 157 lead to naked short selling (NSS) on the markets.....
Phase 1 to NSS a booming market- FAS 157 requires companies to mark to market its financial assets at the exit price in an active market. In a booming market with a lot of credit available, valuations of financial instruments head only one way and that is upupup, valuations are better as there are many takers for these instruments ...net result earnings per share & disclosure analysis of companies look and feel better.
Phase 2 to NSS - Hungry Investors and credit rating agencies - traditionally relied on making their own fair value assumptions on Companies, now with data being available freely in the financial statements, these become the new norm of valuations..sideeffects - reckless lending, bad investments,inaccurate credit ratings of securitized debt and off late betting heavily on Credit Default Swaps (ask Lay-man ooops Lehman). Fair value assumes that markets have "good information" culled from financial results and credit-rating reports. But if rating agencies and investors get their data from corporate financials — "which are themselves based on prices inflated by a market bubble, the accounting numbers support the bubble.
Phase 3 - The bubble gets bigger - As accounting numbers support the bubble, markets instead of relying on prudent valuations and controlling management excess, 'fair' values feed the prices back to the market."
Phase 4 - A Sub prime hits you.........Sub prime loans (meant for the lower echelons) hits credit liquidity in the world markets . This hits liquidity in exotic financial instruments meant for the higher echelons of the Corporate world. With lesser liquidity, there are no takers for financial instruments in an active market - as a result fair values suddenly collapse.
Many banks in the US were complaining that they had no takers for US Govt bonds last quarter... many were wondering as what value they had to ascribe to these bonds... well if you were to follow FAS 157 - record these instruments at exit price.. then zilch should have been the value.
Phase 5 - Hungry Investors (this time bears) and credit rating agencies are back at it again....... they value companies on the basis of fair values in the financial statements, bingo ..... the valuations in the financial statements result in lower enterprise value and earnings per share...sideeffects fresh lending and investments gets starved, inaccurate credit ratings are given for healthy companies, securitization pools look bad, and Credit default swap indices go down (ask Lay-man)
Phase 6 - Bad rating chase bad values, this circular chain worsens the credit crisis. Bears step in and start naked short selling in Companies....their stocks, debt programmes, securitzation portfolios, Lay-man oops Lehmans' Credit Default Swaps.
The crux of this issue is marking assets and liabilites to their exit price in active markets, in times of recession, when there are no active markets, FAS 157 forces companies to mark their assets down, though many of these companies have the stomach to hold onto these investments through the recession.
Well i heard certain punters hedging /betting on what will be the next set of fair values, accountants will disclose for their Companies in the coming quarter ...now that's a new derivative under FAS 133 isnt it...wonder IDSA already has it updated.
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