Climbing Out of the Credit Crunch

Accounting and Reporting

The problems of markets’ efficiency have had a similarly major bearing on accounting valuations. Have accounting standards inadvertently made the credit crunch worse by turning a crisis of liquidity into one of solvency?

In recent months, there has been a keen debate in the accountancy profession about the so–called ‘fair value’ practice of valuing assets not at original purchase price, or ‘historic cost’, but using current market value. While in normal times, this seems sensible, the question arises: what do you do when there is no genuine ‘market’ to mark to? Subjective models have to be used which do not adequately reflect the extreme conditions of the last twelve months. This has contributed to huge bank write–downs, which can then pressurise other players to use the new lower benchmark. This in turn leads to a temptation to sell now, before the price gets even lower, and so the vicious spiral gains momentum.

Some banks and regulators have argued that fair value — one of the key tenets of the International Financial Reporting Standards (IFRS) regime now used in Europe and by listed companies in 100 countries — is making a bad situation worse. Even some accountants have called for a ‘smoothing’ of assets values at average market price over a 12–month period to take the sting out of the downwards slide in an abnormal situation.

We believe that for all the current troubles, the increased transparency of IFRS and fair value makes it still the best model available. Any sort of smoothing will ultimately lead to a diminution of market integrity and openness. It should not be forgotten that historic cost led to stagnant loans and lack of transparency in the Asia–Pacific economies which was shown up in the 1997/8 crisis, and which in turn led to the drive for international accounting standards. More appropriate than yet another revision of accounting standards would be to provide fund managers with better and more consistent guidance for implementation of existing standards.

We believe that for all the current troubles, the increased transparency of IFRS and fair value makes it still the best accounting model available.

All parts of the accountancy profession — preparers, standard–setters, and auditors — must learn from the last year and strengthen the fair value model. They need to define the parameters where profits and losses are struck under fair value. Poor quality loans sliced, diced and parcelled up in a new wrapping with an AAA sticker should not be accepted as assets worth billions of pounds or dollars. Banks balance sheets which included these CDOs did not represent a ‘true and fair’ picture — and even other banks’ willingness in early 2007 to buy them at a falsely high price does not change that fact. The credit crunch is not another Enron as far as the accountancy profession is concerned — though in the extensive use of off–balance sheet vehicles there is a superficial resemblance — but preparers and auditors of accounts in the affected organisations legitimately face questions. If credit ratings agencies and mortgage brokers are most culpable, the accounting profession must learn the lessons from its various roles in this sequence of events.

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