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Fair Value Accounting in the Emerging Economy

By

Evan Pathiratne

Postgraduate and Midcareer Development Unit Faculty of Management and Finance University of Colombo

Fair Value Accounting in the Emerging Economy

CHAPTER 6 FAIR VALUE, FROM A SRI LANKANS PERCEPTION


6.1 PERCEPTION FORM A SENIOR ACCOUNTANT
The global move towards fair value accounting might prove difficult for south Asian countries as they lack active markets to support such valuations was a statement once made by Mr. Reyaz Mihular (chairman of the accounting and auditing standards committee of south Asian federation of accountants, and senior partner at KPMG Ford Rhodes Thornton & Co) at a conference organized by ICASL. (Lanka Business Online, 2009) With the advent of new regulation imposed by the IFRS there is a more increasing trend for the usage of fair value for measurement of assets and liabilities as a consequence of the current trend to of transparency that the stakeholders demand of an entitys performance. He also went on the comment that "this trend poses several challenges to countries in the South Asian region where we do not have active markets to support such fair valuations. (Lanka Business Online, 2009)

6.2 PERCEPTION IN THE INDUSTRY


It has become a controversial topic within the accounting body intellectuals in Sri Lanka where the popular concept is that Fair value' accounting always inflates up profits during an bubble economy (example international cases- the housing bubble in USA in 2007-2009, or the DOT COM bubble in the 90s) allowing companies to show profits larger than they would be under standard historical cost accounting. When inevitably the bubble collapses, the inverse takes place, increasing the volatility in reported profits. . The next chapter explains a different view point to the above mentioned ideology.

Fair Value Accounting in the Emerging Economy

CHAPTER 7 FAIR VALUE IN CONTEXT - IS IT FAIR TO BLAME FAIR VALUE ACCOUNTING FOR THE FINANCIAL CRISIS?
7.1 INTRODUCTION
When looking into the concept of Fair Value in the emerging economy, the connection and correlation it has with a financial meltdown is also a controversial topic that is worth discussing. The Economist magazine on a article published in 2009 on the topic of The crisis and fair-value accounting made the following comments the fair-value revolution is incomplete. Regulators may need to abandon the traditional, mechanistic link between accounting and capital adequacy rules if they really want to try to fight a banking crisis. That is no bad thing either. Investors and regulators should be able to share a market-based language to describe financial problems, even if they disagree about what needs to be done. (The Economist, 2009) An article on the topic of Is It Fair to Blame Fair Value accounting for the Financial Crisis? was published under the 2009 November issue of Harvard Business Review magazine (written by Robert C. Pozen is the chairman of MFS Investment Management, a global money management, and a senior lecturer at Harvard Business School). It provides a critical evaluation on the concept of fair value and tries to debunk the preconceived notions had on fair value and its disadvantages. Below is stated some of the key points of discussion in the article.

7.2 VIEWPOINTS FROM INDUSTRY EXPERTS


Lisa Koonce, an accounting professor at the University of Texas stated that This is simply a case of blaming the messenger. Fair value accounting is not the cause of the current crisis. Rather, it communicated the effects of such bad decisions as granting subprime loans and writing credit default swaps (Pozen ,2009) Steve Forbes, chairman of Forbes Media thinks mark-to-market accounting was the principal reason that the U.S. financial system melted down in 2008. (Pozen ,2009)

Fair Value Accounting in the Emerging Economy

7.3 THE 3 MYTHS ABOUT FAIR VALUE ACCOUNTING


Myth 1: Historical cost accounting has no connection to current market value There are certain cases when even under historical accounting; current market values are factored into financial statements. The regulators require publicly companies to check whether if any assets are permanently impaired that is, whether their market value is likely to remain materially below their historical cost for an extended period. If the impairment is not just temporary, the company must write the asset down to its current market value on its balance sheet (resulting loss on its income statement.) This means that even under historical cost accounting, banks & financial institutes are ultimately forced to report any permanent decrease in the market value of their loans and securities, albeit more slowly and in larger lumps than under fair value accounting. (Pozen, 2009) Myth 2: Most assets of financial institutions are marked to market Why? Under fair value accounting, management must divide all loans and securities into a maximum of three asset categories: those that are held, those that are traded, and those that are available for sale. If management has the intent and ability to hold loans or securities to maturity, they are carried on the books at historical cost. Most loans and many bonds are held to maturity; they will be written down only if permanently impaired. (Pozen, 2009) Myth 3: Assets must be valued at current market prices even if the market for them is illiquid The rule was designed to allow more securities to be valued by bank models instead of by market indicators. Also there was a rule issued yet another rule on how to account for securities when they were permanently impaired. Those two retroactive rulings made it possible for large U.S. banks to significantly reduce the size of write-downs they took on assets in the first quarter of 2009. The rulings improved the short-term financial picture of these banks, although they also led bank executives to resist sales of toxic assets at what investors believed to be reasonable prices.(Pozen, 2009)

Fair Value Accounting in the Emerging Economy

7.4 PROPOSED MEANS FOR A WAY FORWARD


The authors of the article Is It Fair to Blame Fair Value accounting for the Financial Crisis? Propagate the notion that income volatility would be better understood by its public stakeholder if banks published two EPS figures one with assets recorded at fair value and the other without. And the fair value accounting approach of marking to model could gain some credibility with investors if the underlining assumptions in these models are disclosed. Even though after the above discussion it seems historical accounting and fair value accounting is more closer than one think the differences between the two forms of accounting may be significant for a particular bank on a specific reporting date. .If banks published a reconciliation of their net cash flow with their net income under fair value accounting, investors would be able to clearly see what portion of operating income came from operating earnings and what portion came from movements in the securities markets. The table below illustrates how this would work.. (Pozen ,2009) The next page shows format proposed by the authors for a new financial statement, its a partial reconciliation of a companys net income under fair value accounting (YYY in the table) with its net cash flow, without fair market adjustments (XXX).

Removing the cash flow from the income statement is practice used by securities analysts to better understand a companys financial state. Investors can understand the percentage of a banks net income came from operating earnings and what percentage came from securities markets movements Bank executives can now logically understand and elaborate how their banks were earning profits from operations, regardless of periodic price fluctuations in securities holdings if any.

Fair Value Accounting in the Emerging Economy

Figure 1 : Proposed New Format for a Financial Statement , to reduce misinterpretation of Banking assets

Even with such proposed amendments with the current advent of the EU economy the banks in the sector is having problems with fair value. Royal Bank of Scotland made a big net loss in the first quarter of the year. But most of that was down to a 2.46 billion charge for the fair value of the lenders own debt. Its an absolute mess, said Mike Trippitt at Oriel Securities. At the moment we are seeing fair value gone mad with swings of 2 billion per quarter. (The Wall street Journal,2012)

Fair Value Accounting in the Emerging Economy

REFERENCES
(2008) How Fair Is Fair-Value [WWW] Available from:

1. Forbes

Accounting?

http://www.forbes.com/2008/06/24/accounting-banking-sec-biz-cx_lm_0625sec.html [Accessed 2012/05/22]. 2. Lanka Business Online (2009) Sri Lanka says move to fair value accounting difficult

[WWW] Available from: http://www.lankabusinessonline.com/fullstory.php?nid=1029881417 [Accessed 2012/05/19]. 3. Pozen R.C (2009) It Fair to Blame Fair Value accounting for the Financial Crisis? Harvard Business Review, November 2009 , p. 85-92 . 4. The Economist Newspaper Limited (2009) The crisis and fair-value accounting [WWW] Available from: www.economist.com/node/12274096 [Accessed 2012/05/22]. 5. The Wall Street Journal (2012) Fair Value Accounting Haunts Banking Sector [WWW] Available from:http://blogs.wsj.com/source/2012/05/04/fair-value-accounting-haunts-banking-

sector/ [Accessed 2012/05/22].

Fair Value Accounting in the Emerging Economy