Consulting Corner

Fair Value & Cost-Based Accounting
by Andrew Davidson

Fair Value has been creeping into GAAP for a number of years. In the mortgage market, servicing assets as well as retained residuals from securitizations are recorded at fair value. In addition, under FAS 133, derivatives are marked to market on the balance sheet, but their treatment for income varies.

These steps toward fair value accounting have not been uniformly positive. In fact, fair value accounting may have caused more problems than it solved. The failures of the specialty finance industry may be traced, in part, to inflated fair values for residuals. Furthermore, the disparity of servicing values among firms has been the source of extensive criticism of the mortgage banking industry.

The differing treatment of assets, liabilities and hedges in GAAP has caused additional confusion. Often we find that firms cannot implement economically effective hedging strategies because the treatment under FAS 133 will cause excessive swings in income. Freddie Mac's accounting troubles extend, at least in part, from their attempt to produce accounting statements that reflect the true economics of their firm better than GAAP. Their restatements, which show large gains in asset values and hedges, but do not show the corresponding changes in liability values, while in accord with GAAP, fail to provide a true picture of their financial status.

With this background in mind, we cautiously recommend a more complete move to fair value accounting, but with sufficient links back to traditional cost-based accounting to provide investors with a clear picture of a firm's financial condition.

We believe that fair value accounting statements should satisfy three principles:
      • Accounting statements should show, not just the current fair value of the firm, but how that value has been created.
      • Investors and other stakeholder should be provided with sufficient information to assess the quality of the fair value estimates.
      • While there may be arbitrary decisions about where to place items on the balance sheet,              every effort should be made to treat all financial instruments and even non-financial instruments the        same way. >>>