Mark to Make Believe

(Second of four parts)

What Drives the Application of Fair Value Accounting?

“Mark to market” or MTM was the term originally used in futures exchanges to refer to the use of end-of-day market prices to value trading portfolios in order to determine the required margin to protect the exchange from losses. Compared to preserving the historical costs of the underlying assets, marking to market has been found to more accurately reflect the financial condition of the portfolio in the sense that if a trader liquidated his position at close of the trading day, the carrying value in the books would represent the “cash or hard value” of the net assets, while any gain or loss to be realized from the theoretical sale of the portfolio would be equivalent to the unrealized gain or loss in the books. This practice eventually caught the eyes of the accounting standard setters and gradually crept into the accounting standards, both those under IFRS and US GAAP. In adopting fair value accounting, standard setters addressed financial reporting issues related to making asset values “more realistic” and less misleading. In the years prior to the full implementation of fair value accounting, many financial statement users complained about how unrealistic and misleading asset values had been under the historical cost basis especially if the corresponding market values are volatile or significantly discrepant from the carrying values of the assets. There would have been no practical justification to continue using historical cost as most financial analysts have been adjusting asset values anyway to the prevailing prices in order to obtain a better picture of an entity’s financial condition.

Fair value accounting, under both IFRS and US GAAP, applies mostly to financial instruments. It is the benchmark measurement approach in valuing all financial instruments including derivatives, subject to certain exemptions. The exemptions are triggered by the entity’s intention in holding the financial assets. Putting it in proper perspective, the entity’s intention determines classification while classification selects the measurement basis to be used (whether fair value or amortized cost). Under IFRS, for financial assets quoted in an active market, if the entity has both the positive intent and ability to hold these assets up to maturity, then it is allowed to classify the assets as part of its “Held-to-Maturity” (HTM) portfolio which is carried at amortized cost. In the case of unquoted assets, the positive intent and the ability to hold debt securities to maturity is no longer required for the entity to classify these assets as part of “Loans and Receivables” (L&R), which are also carried at amortized cost. The criteria to using historical cost are noticeably more stringent for HTM because the intention needs to be clearly supported by an entity’s action (hence the positive intent and ability requirement) as an entity is not allowed to dispose nor reclassify (except under certain circumstances) more than an insignificant portion of the portfolio prior to maturity, otherwise the whole portfolio would be tainted. Once tainted, the HTM portfolio is required to be marked to market and classified as part of the “Available for Sale” category. Tainting precludes an entity from using the HTM category for two consecutive years after the year of tainting. The more stringent requirement for HTM was imposed by the IASB because the temptation to profitably dispose of or reclassify quoted securities prior to maturity is greater on account of the availability of an active market.

The Evil That is Fair Value Accounting

It was only a matter of time before fair value accounting lost its steam and short-lived popularity. Many analysts and investment managers observed that, prior to the liquidity crunch, stock prices were rapidly dropping into a free fall as an immediate reaction to or in anticipation of announcements of huge losses incurred by big financial institutions. Initially, these losses were connected to legitimate credit losses from defaults. The sudden rise in defaults has been tied to loose credit screening practices of the lending companies. Prices of mortgage-backed securities (MBS) were expected to be severely affected by the rise in credit losses on the underlying loan portfolio but experienced a much worse hit. As opposed to mortgage loans, MBS prices are based more on perception rather than their intrinsic value. And as panic spread throughout the financial markets, MBS prices kept dropping incessantly.

Enter fair value accounting. Since most MBS were either held for trading or short-term investment, IFRS and US GAAP required MBS investments to be carried at fair value. The quoted prices available were (or should I say “still are?”) however tainted with so much investor paranoia and irrationality. Because the markets for these assets are distressed, the MBS were observed to be valued at “fire sale prices” which some believe may be significantly below the present value of actual cash flows from the underlying investments and reflect more the sentiment of the buyers. The use of the prevailing market prices blasted whatever earnings and net worth that an entity (an investment house or a bank) may have accumulated over the years into pieces. Then came the end of another quarter, with publicly listed entities being forced to report their results of operations which are heavily distorted by hefty losses from marking to market its investments in MBS and related instruments. The funny thing is that, in the first place, these investments are not even part of their core businesses.

Share prices then took another hit, unfortunately, amplified again by investor fear. This perception again spreads to the MBS market, setting a vicious cycle that seems to be in perpetual motion and, in recent months, has shown no signs of letting up even though company after company have either declared bankruptcy or teetered on the brink of disaster or have been bailed out by the government. This downward spiral shuts down lending to these companies, so they lose all liquidity (cash on hand) needed to keep company operations going. Stockholders — realizing that they will be wiped out if the companies go into bankruptcy or get taken over by the government — start panic selling, even when they know the underlying business of the company is fine, sending stock prices on a much faster pace downwards. As for some entities, this also triggered a margin call, where creditors that had provided the funds using the MBS as collateral exercised their contractual rights to get their invested funds back. This resulted in further forced sales of MBS and emergency efforts were undertaken to pay off the margin call. The unprecedented markdowns also reduced the value of the regulatory capital of banks requiring additional capital infusion and creating further negative perception and uncertainty towards the health of banks. This forced the banks to obtain high cost funds which further dragged down their earnings. (To be continued)

(Paul Bernard D. Causon is a Partner for Audit Services of Manabat Sanagustin & Co., CPAs, a member firm of KPMG network of independent member firms affiliated with KPMG International, a Swiss cooperative. This article is for general information only and is not intended to be, nor is it a substitute for, informed professional advice. While due care was exercised to ensure the quality of the information contained in this article, readers should carefully evaluate its accuracy, completeness and relevance for their purposes, and should obtain any appropriate professional advice relevant to their particular circumstances. For comments or inquiries, please email [email protected] or [email protected]).