I am ambivalent about fair value accounting standards because they ruin comparability of financial statements across companies. Recently, SFAS 159 has come into the news because some securities firms used it to book gains because the market value of debt that they issued had fallen. Four notes:
1) They had no choice, they had to do it. Their debt has liquid markets — those are level 1 and at worst level 2 liabilities.
2) Many of the assets that they carry have credit risk also. The pressures that are leading the prices of their debt to fall, are also causing the carrying value of some of their assets to fall as well.
3) If credit markets for their debt improve, they will have to write those liabilities up to higher values. Even if creditworthiness stays the same, the passage of time will make the liabilities rises in value as they get closer to the ultimate payoff.
4) In bankruptcy, their obligation to pay par does not change. It is not as if they can pay the reduced market value to pay off their debt, except through a deal agreed to by the court and plaintiffs.
Look, I don’t like the confusion SFAS 159 creates at this point any more than the next guy, but the gains here will likely reverse over time, absent bankruptcy. As an analyst, I strip those gains out of income, and I should strip out losses on the asset side that I think will reverse as well.
We can change the way that gains and losses are reported — book, market, model, hybrid… but we can’t change the ultimate cash flows from the business, which is what will ultimately drive the value of the firm. Be careful and conservative here, as accrual entries get more subjective, they become less trustworthy, and managements on average release more into income from accrual entries than they ought to.
It is also worth considering how FAS159 would have behaved pre-crisis when credit spreads were getting tighter and tighter for many years. In this environment, the companies own debt would be increasing in value along with the assets; but the assets would be increasing much faster. The liability revaluation dampens the otherwise excessive volatility of the firm’s net worth. It acts as a brake in both directions. I see this as a better framework than any other. The real challenge is the stupidity of the income statement. It should really just be an attribution of the change in the balance sheet. The core or recurring earnings part should strip out the excess mark-to-market of both the assets and liabilities and attempt to measure that part of the change in net worth attributable to long term changes in expected cash flows and new business.
On #1…FAS159 does not require companies to mark their debt. It gives them an option, for better or for worse. (The standard is actually titled, the Fair Value Option). They didn’t have to mark anything. In fact, they can selectively choose which items to mark (and they would be level 2, unless they are exchange traded). The purpose of this is to lock in hedged transactions… buy debt at a price and issue a bond… in a one for one transaction, carrying both at fv better reflects the economics of the position. Especially from an interest rate perspective – before the fv option, an increase in interest rates would kill a fixed rate asset but the debt would be left unchanged (amortized basis). So an artificial loss is generated, even though a spread is locked in at inception. The value of the trade is whether the spread difference adequately covers the credit risk… which is reflected in the net P/L of the two instruments.
As credit risk changes, so does profitability of the trade.
I do agree that on long-term general corp obligations, if a company where to elect the FV option (not sure why they would), it would be somewhat misleading in the short term.
Charles – an attribution of the change in the balance sheet = the cash flow statement.
James, you are right, FAS 159 is optional, it is just that almost of the major players on Wall Street opted to adopt it. I think that it was in their interest to do so, and besides, whether right or wrong, FASB has been pushing for “fair value” accounting. If convergence with IFRS does not happen, FASB will make something like FAS 159 mandatory, in my opinion.
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