Fitch Weighs in on Fair Value Accounting
Fitch Ratings today defended fair value accounting methods, but argued that greater judgment is needed in arriving at a true fair value.
Volatile and unstable conditions in the financial markets have caused many reporting financial institutions to call for a relaxation of fair value accounting, allowing issuers the option of when to apply fair value measurement and when to apply historical cost.
In a special report Fitch says companies should not stop accounting for assets at fair value in illiquid markets. However, better disclosure is required as to the rationale, assumptions and sensitivities behind these valuations.
“The most salient issue is not whether fair value per se should be used to report numbers, but how that fair value should be measured,” says Bridget Gandy, Managing Director in Fitch’s Credit Policy Group. “If values are being taken from markets that are not striking a fair balance between buyers and sellers, it is hard to argue that those values are fair.”
In the report, Fair Value Accounting: Is It Helpful In Illiquid Markets?, Fitch notes that fair values are helpful to analysts and investors when they represent realistic and reliable indications of the net present values of future cash flows. “The disconnect with market prices comes when there is no intention to sell an asset in the short term and a lack of market liquidity means that current values are either much higher or much lower than the amount that will ultimately be received for the asset. However, holding assets in trading books is a clear indication of a company’s intent to sell in the short term and market values should be taken.”
When market liquidity has dried up, resulting in market prices that tell little about future cash flows of an entity that can hold onto an asset, clinging onto a strict interpretation of rules rather than exercising judgement can make a nonsense of financial reporting.
Fitch would not support any loosening of accounting that enabled companies to move assets from one place in the balance sheet to another, because this would leave accounting wide open to profit smoothing. However, in terms of measuring the fair value of an asset in an illiquid market, a company’s own discounted cash flow measurement may well provide a better indication of its “fair” value and provide analysts and investors with better information about future cash flows than the latest market transaction price.
More extensive disclosure will help investors to understand the limitations around the values reported, Fitch says. “These should include indications of market prices versus expected cash flows, amounts companies expect to lose in real cash on assets written down to market values and how such assets will be funded whilst they are held for longer than originally anticipated.”
“While Fitch does not think that market prices not directly related to the assets being valued using internal models should be required as inputs, the agency also does not think that they should be ignored. A company that is not using the best observable data available should explain why it is not using this, demonstrate why the alternative measurement is more appropriate and provide an indication of how the value would have differed if the market prices were used as inputs in the notes to the accounts.”
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