Fair Value Is Not a Just or Proper Price

Implications: PCAOB’s chairman Mark Olson has said of SFAS No.159: "The increased use of fair value accounting poses a challenge for auditors and the PCAOB." Time is short as this SFAS goes into effect for most companies for financial years beginning after November 15, 2007, except for early adopters. The new standards cover valuations of stocks, bonds, loans, warranty obligations, and interest rate hedges when the Fair Value option is elected. Under existing PCAOB standards, the auditors need to understand how such estimates are derived and may have to develop independent estimates when independent data is available. Both SFAS No.159, “The Fair Value Option for Financial Assets and Financial Liabilities” and No.157 “Fair Value Measurements”, are going to have a great impact on how financial information is presented and the additional testing, both factual and procedural to properly audit it.

Analysis:  

The whole concept of Fair Value discredited by Adam Smith, and has been considered to be functionally dead for centuries, under the name of just price. In a market place just compensation is based on a price consented to by both a buyer and a seller. Fear of ‘just price’ calculations are in the Constitution in the takings clause of the Fifth Amendment. The founders were very suspicious of takings and the use of just price to value them.

When a mutually negotiated price does not exist, you have a forced sale which in this case that the firm’s assets are worth what management says they are, not the market. As in any forced sale or taking, the valuation is based on proxies such as prices for “comparable” properties, which are often not identical. When there is a market, many things can be priced, but these two SFAS range from a market for fungibles, such as stocks or commodities, to estimates.

The subprime market shows the result of such manipulation. See this article: http://www.nypost.com/seven/06202007/business/subprime_street_is_feeling_the_heat_business_roddy_boyd.htm

“Carrington has raised eyebrows among rivals with its portfolio-valuation methods. The fund values its bonds based on the amount of principal and interest payments the bond is anticipated to make, while most funds use current trading levels.”

Here we have an example of how Fair Value can be misleading and non-transparent. As a note, Lehman and Credit Suisse have already auctioned off their share at 50 cents on the dollar, and Merrill traders would be happy if they can get that much. Carrington’s valuation, by their own methods is up while other similar funds are down.

Before going into some of the specifics, let’s engage in a bit of levity. A man walks in to a fruit store, and notes that bananas are $2.00 per lbs. He and the owner have the following exchange:

Customer: Nick’s price is $1.50 per lbs.

Owner: Well does he have any bananas, today?

Customer: No, he’s sold out.

Owner: Well, when I don’t have bananas, my price is $1.25.

As you can see, without offer and acceptance the very idea of a price becomes a joke.

Clearly the accounting profession is steadily distancing itself from the market and value based on freely consented transactions. It should be noted that a large part of the buyout business is based on revaluing assets for both book and tax purposes based on arms length transactions, rather than estimate. Assets values, in these deals, are more firmly based in reality for that reason. Heretofore, no one wanted to change asset value for any other reason because free exchange is the actual arbiter of value.

The first obvious and necessary change related to inventory values for anyone actively trading financial instruments: brokers and dealers. Marking to market has proved to be reliable and is subject to many limits related to concentration and marketability. More to the point the instruments are fungible and traded.

It would seem that the most visible change to estimates is based on compensatory stock options. The methodology is academically sound, but meaningless. First, the cost is non-cash and will not be monetized until sometime in the future. Less noticed, is that management can influence options value by making shares more volatile, and that can be accomplished by increasing leverage. The only good thing about the issue is that many companies are ending these plans: the true costs are hard to estimate, and shareholders are growing to dislike them, seeing stock options as dilutive and harmful to their investments.

There are difficulties however with this sort of application. In a 2006 academic commissioned be PCAOB. Jay Rich, a coauthor of the report stated: “No auditor can keep up with all this stuff. [The audit firms] need to have someone who specializes in valuation in place.” The tools used in SFAS No. 147 are finance oriented and are not nor would be expected to be part of the auditors training. Even with the emphasis on internal control checks, it would be doubtful that a person not trained in the field could design or assess controls over the process. Further, the auditors are not to attack these estimates even though time may prove them flawed during the audit.

In another CFO article, “The FAS 159 Mulligan” (http://www.cfo.com/article.cfm/9139916?f=related). Neri Bukspan, chief accountant at Standard & Poor's and a member of FASB's User Advisory Council felt that if it were used to hide losses or generate short-term gain it would be a problem. "If prudently used, [FAS 159] is beneficial," because it increases transparency, mitigates volatility, and gives investors a more realistic picture of the company. But in the wrong hands, it's a great concern, "It should be noted that the concerns were voiced in an article which raised concerns about an article directed at early adoption under paragraph 30.

I am surprised that a member of the User Advisory Council would argue that the statement increase transparency then provides a number of caveats. On the other hand, I have documented several of instances where I feel that user interests could be harmed by certain FASB/SEC actions, and worse that the proposals were blind to how financial information is used.

The substitution of Fair Value for market exchanges is a return to medieval thinking that most believe has been totally discredited by Adam Smith and two centuries of hard experience. If anything, this new format decreases transparency. The user does not care about intermediate values, but rather at what price the asset or liability may be liquidated for cash. Further, it is their responsibility to make that judgment and not accountants who lack the training to do so in the necessary way.

The only conclusion that can be drawn is that the accounting profession embodied by the FASB and the SEC is into matters of which they have no understanding, in ways that are either a waste of user time, or worse obscure critical information.