Here is a piece reporting on a public address by Penman, one of your authors, to practitioners and academics at Singapore Management University in 2010 when the financial crisis of 2008-2009 was still firm in memory. It is a little dated, with both the FASB and the IASB now backing off fair value accounting.
Wait not for another crisis: Weighing in on the fair value accounting debate
Before the 2007-8 financial crisis brought everyone back to earth, fair value accounting was in the vogue, akin the blue-eyed boy of accounting. However, when the crash happened, politicians, policy analysts and pundits looking for something, someone to blame, lined up fair value accounting against the wall together, with regulators asleep at the watch, excessive use of leverage, and so on. Fair value accounting – simply defined as the booking of numbers based on current market value — was named a catalyst in exacerbating the crisis.
From the rubbles of the fall sparked by the America’s sub-prime real estate crisis, the International Accounting Standards Board (IASB) and the US Financial Accounting Standards Board (FASB) came together in late 2008 to reconsider all aspects of the accounting for financial instruments and try to develop common fair value measurement guidance.
“One more crisis”
To “fair” or not to “fair” — this, according to Professor Stephen H. Penman, is now “the big debate in accounting”. Penman, who is George O. May Professor and the Morgan Stanley Research Scholar in the Graduate School of Business, Columbia University, was speaking at Singapore Management University. The title of his talk was “Accounting for Value: Is Fair Value Accounting Fair Accounting for Shareholder Value?”
It is a debate that Singapore cannot avoid paying attention to, given its bid to become the regional financial centre and the Singapore Accounting and Standards Council’s commitment to fully adopt the International Financial Reporting Standards (IFRS) developed by the IASB by 2012. What the two major accounting standards bodies ultimately decide on will have implications not only on how companies in Singapore will have to book their accounts in future, but also affect the external financial environment in which the island’s wide-open economy will have to navigate.
To where are the winds blowing on this fair value issue? Has the crash and bang of the last crisis changed the perception towards fair value accounting? Will fair value accounting continue to gain popularity? After all, fair value, despite the criticisms, gives potential investors the current market value of financial instruments. Penman’s answer, to laughter from the audience, was: “I think there has to be one more crisis.” Clearly, for this on-going discussion, there is still some way to go.
FASB vs IASB
Indeed, FASB and IASB appear to be seeking not so much to remove fair values from balance sheets all over the world, but to determine the extent it would advance. In America, the scale seems to be tilting towards more fair value, with the FASB proposing that all financial instruments, including bank loans and deposits, be reported at fair value. On the other hand, the international body, IASB, leans towards a mix of fair value and amortised cost, seeking to retain amortised cost accounting for bank loans, although with the option of fair value accounting.
The public consultation process on the respective proposals is still on-going so the dust has not settled yet. Nevertheless, the FASB’s proposal, in particular the momentum towards fair-valuing bank loans and core deposits, worries Penman.
“This is quite a radical stand. We in accounting have always had the discipline to say that you don’t book assets from customers from the trading account until the customer turns up and actually gives you a claim against them,” said Penman, a one-time winner of the Contribution to Accounting Literature Award by the American Accounting Association and the American Institute of Certified Public Accountants (CPA) – one of the highest distinctions awarded to accounting academics.
Yet in an attempt to recognise and value intangible assets, the FASB is proposing that “in calculating the present value of the average core deposit liability amount, entities should consider future core deposits”. To which, Penman noted that this is not the same as the mark-to-market account, but is for the bank to estimate what deposits it would get in the future and put it in the accounts. “Think about it. If any manager of a business starts booking future sales or starts booking sales when we don’t have a customer, we lock them up. We say ‘How can you!’” he said.
Graham’s value
A self-professed disciple of the so-called Benjamin Graham doctrine of fundamental investing, Penman refutes fair-value proponents’ argument that historical cost accounting is like driving down the street looking in the rear-vision direction. Instead, he argues that historical cost accounting “is quite forward looking” because “if I know the sales now, the margins, I’m going to have a very good predictor of what the future value might be.”
Graham, (1894 – 1976), is an American economist and Wall Street analyst who authored the classic bestseller “The Intelligent Investor”, famously described by Warren Buffett, Sage of Omaha, as “the best book about investing ever written.” Graham, according to Penman, teaches one to beware of prices. “Price is not value. Price is what you pay, value is what you get. There is a difference,” he said.
Penman added that there must a distinct line between what one knows and what one is speculating. Almost by default, there is some element of speculation for any investor as no one can say and ensure what the future will be. To be sure, there is nothing fundamentally wrong with speculation. What Graham teaches is not so much not to speculate, but to base speculation on known factors. Only then can investors challenge the price. And in challenging the price, Graham’s advice is to be very careful not to include price in the calculation because then one loses the ability to challenge the price.
So what does this mean for accounting professionals? According to Penman, instead of trying to conjecture the current prices of assets and liabilities, accountants should remember that it is not their job to speculate on prices – leave that to the analysts and the investors they serve. Rather, he said, accountants should keep prices out of the accounting so that speculation by analysts and investors can be based on a history of objective evidence. To do otherwise is to inject “water in the balance sheet” that quickly vaporises when the sun comes out. There have been plenty of significant lessons in this aspect: the Great Depression in 1929, the technology bubble in late 1990s, the Enron debacle in 2001, and most recently, the US housing crisis.
Greasing the wheels
During the talk, Penman also elaborated on how the use of fair value accounting played a part in the crisis. Loan securitisation, which began some two decades ago, took off in a big way in the years leading up to the bust – but not before originating banks, mortgage brokers, the securities industry, merrily enticed home buyers to take up cheap loans and then packaging them and hawking them off as investment grade products sold throughout the financial system.
With fair value accounting, these securities were marked-to-market, moving the loans away from the information at the originating banks. At the same time, the banks were easy with their lending, and interest rates kept at historical low to fuel the post 9-11 economy. The due diligence to determine credit worthiness of the borrower became so minimal that Penman said it even did not require tax returns and 10 minutes was all it took for loans to be approved.
So, while the economy was chugging nicely along, interest rates kept predictably low, and real estate prices were moving upwards, such practices could still be sustained. However, a huge bubble mortgages, with dubious credit worthiness, was also being created. This bubble was also pushing up the fair value of loans made out by the banks.
Simply put, banks were then lending against bubble prices in their books, dividends and bonuses were paid out of fake profits, increasing leverage and perpetuating the vicious cycle. When the crash came, big chunks of the market basically vapourised and fair-valued prices plunged, forcing lenders to take huge write-downs, pushing their bottom line deep into the red. “Clearly, cheap money was a problem, so was securitisation and leverage, but fair value accounting was the grease in the wheel,” said Penman.
Risky special vehicles
The key problem, according to Penman, is that fair value accounting flies in the face of conventional accounting wisdom, which demands that accounting should be independent and earnings have to be earned. Yet, fair value accounting gives earnings as estimates based on management’s expectations. This has the effect of magnifying risks that investors have to bear, opening the door for accounting acrobatics performed using the likes of Special Purpose Entity (SPE) and Structure Investment Vehicle (SIV) that were kept off the balance sheet, to come back and bite investors. Thanks to the Enron debacle, and the sub-prime mortgage crisis, SPE and SIV have become bywords not for savvy financial engineering but for skeletons in the closet.
Furthermore, with fair value accounting, borrowing is no longer against hard assets but against expectations. It also encourages dividends and bonuses to be paid out of conjectured profits, which Penman denounce as a “Ponzi scheme” that pays dividends without having actually realised value. He pointed out that fair value accounting is merely a journal entry, not a real cash transaction, meaning the company has to borrow to pay the dividends. Little wonder that the end result is an outrage American public angry with Wall Street executives paying themselves huge bonuses out of fair value profits and with the subsequent massive government bailouts justified by reasons like “too big to fail”, leaving American tax payers to hold the bag.
Hedge funds and coal furnaces
So if fair value accounting in its current formulation helps to create bubbles and pro-cyclical pressure, what is the alternative? The solution might come from a quarter of the financial industry not exactly the most well-known for its stability and transparency: hedge funds. Penman observes that while hedge funds employ fair value accounting, or mark-to-market accounting if there are liquid assets, and they do this as a voluntary association, where the agreement with investors is to trade in and out of the fund at net asset value (NAV).
However, there is a control. That is, when there is doubt about the value, the fund gets locked up or side pockets, that cannot be traded, are established until the uncertainty is resolved. The moral of the story as Penman puts it is: “Let’s not recognise value-added in business until you get or realise value. Don’t trade until resolution of uncertainty.”
Another way of appropriately applying fair value accounting is when shareholders’ value varies one-to-one with market price. For example, if you hold a bond and the price of the bond goes up, fair value is appropriate as your business is in trading market prices.
However, for most businesses, including lending and borrowing banks, they are not in the business of trading prices. Instead, they are in the business of producing income. For example, if a steel company holds a pile of coal, it does not actually make money if the price of coal goes up. Instead, it does so by feeding the coal into the blast furnace where steel is produced, and then buyers found, and finally, recognising value from the output price of selling the steel and the input price of buying coal. In other words, most businesses do not get value from exit prices but from arbitraging market prices. To them, exit price is only the revenue, and not profit.
Fair value is also appropriate if you have a matched balance sheet. According to Penman, the common misconception about fair value accounting is to focus on updating old costs and getting the balance sheet right to indicate asset value. However, it is not possible to recognise lost or gain on an asset without recognising lost on liability.
Accounting for loans
And when it comes to loan accounting, Penman proposes the following steps: first, the bank makes the loan but records loan at historical transaction amount. Then for a few years, it simply recognises or records interest income at the risk free rate until credit worthiness has been established. Only when the customer’s credit worthiness has been established by indicators that the bank had previously laid down – such as when the customer has been keeping up payment and customer’s income is going up – does the bank then recognise the difference between the risk free rate and the loan rate.
Noting that banks are in the business of making money by exposing themselves to credit risks, Penman’s suggestion is that they should thus only recognise and book credit premium and amortise the income over the number of years when they make money on the credit risk. That way, instead of recognising value arbitrarily through fair value accounting and taking the hit when the customer cannot follow-through, the bank adheres to strict accounting standards, where value is not recognised until the customer has performed.
Penman acknowledges that his idea is “very conservative accounting”, which probably won’t sit down well with the risk-taking culture of many finance hot shots – the same people who helped agitate the recent crisis. “For most loans that are not growing it wouldn’t make much of a difference, but in a growing business, it makes a difference – such as lending to more sub-prime people,” said Penman.
Hopefully, there is no need for another crisis, before lessons like these sink in.