Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

FASB may kill fair value accounting by permitting it

I have long argued that the alternative to fair value accounting is
unfair value accounting and so I should normally be cheering the proposal
by the Financial Accounting Standards Board (FASB) to permit fair value
accounting for financial assets and liabilities. But actually, I
am not happy at all.

The FASB’s
Exposure Draft
entitled The Fair Value Option for Financial Assets and Financial Liabilities
“would create a fair value option under which an entity may irrevocably
elect fair value as the initial and subsequent measurement attribute for
certain financial assets and financial liabilities on a contract-by-contract basis,
with changes in fair value recognized in earnings as those changes occur.” There
are two problems with this exposure draft. First is that the fair value option
can be exercised on a contract by contract basis allowing the company to chery pick
profitable contracts to show on fair value basis while showing the loss making
contracts on historical cost basis. The requirement that the fair value election
is irrevocable provides only partial protection against this. The second problem
that aggravates the cherry picking danger is that there are no safeguards at all
on how this option can be exercised. Comparing its proposal with International
Accounting Standard 39 (IAS 39), the FASB states:

This Statement has no eligibility criteria for financial assets and financial
liabilities, whereas IAS 39 (as revised in 2005) indicates that, for other than
hybrid instruments, the fair value option can be applied only when doing so
results in more relevant information either because it eliminates or significantly
reduces a measurement or recognition inconsistency (that is, an accounting mismatch)
that would otherwise arise from measuring assets or liabilities or recognizing the
gains and losses on them on different bases, or because a group of financial
assets, financial liabilities, or both is managed and its performance is evaluated
on a fair value basis, in accordance with a documented risk management or investment
strategy, and information about the group is provided internally on that basis to
the entity’s key management personnel.

The FASB proposal thus threatens to make fair value accounting very attractive
to the scoundrels. The market recognizing this would penalize any entity
that exercises this option. Thus fair value accounting would be killed by
a proposal that professes to permit it.

I think fair value accounting should be the default method for all financial
assets and liabilities. Companies should be allowed to irrevocably elect
historical cost accounting (on an asset class by asset class basis) if they can
show that this is more relevant and reliable because
(a) market prices are not readily available and (b) fair values estimates have
too much subjectivity.

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