Bear Stearns, Enron, And Warnings On Fair Value

As has been widely reported in the business media, New York-based Bear Stearns recently announced a $3.2 billion bail out of two of its hedge funds, due to investments in subprime mortgage loans (basically, home loans to borrowers with bad credit). Although the funds had been using fair value accounting to calculate the assets’ worth, the collapse caught many by surprise—largely because it is extremely difficult to value assets that do not have a ready liquid market. The funds ran into trouble when a downturn in parts of the housing market negatively impacted the funds’ investments in complex securities backed by subprime mortgages; since the securities are not frequently traded, the “fair value” is difficult to determine. Borrowed money was used in an attempt to save the funds.

The beginning of the end for Enron was the company’s penchant for manipulating fair value calculations to its advantage—recording revenue on transactions that would not be profitable for several years out. It was a great earnings story, but didn’t match up with the fact that the company had no cash, and continually had to increase borrowings. That’s when it began creating off-balance-sheet debt transactions to conceal the disparity.

So, what do these two events at Enron and Bear Stearns have in common? Well, among other things, both used fair value accounting to appraise assets that had no ready market. Of course, that is exactly what the Financial Accounting Standards Board wanted, as did organizations that represent the analyst community.

Over the last few years, this concept of “fair value measurements” has moved front-and-center in the accounting and financial reporting debate. That’s partially because many players in the financial markets argue that fair value is much more accurate and timely than historical cost-based measurements. Indeed, some groups that represent the analyst community will say that “fair value” is the only value that matters.

Another reason for the emphasis on fair value is the ongoing convergence of international accounting standards. In fact, FASB has gone out of its way to embrace the model and has made significant progress on its fair value projects. In September 2006, for example, the Board adopted Financial Accounting Standard No. 157, Fair Value Measurements. The standard governs how fair value should be measured, outlining a hierarchy that ranges from market value for assets and liabilities with ready markets, to the so-called “Level 3” values for assets and liabilities that have no ready market. In February 2007, FASB adopted FAS No.159, Fair Value Option for Financial Assets and Liabilities. That standard allows a company to elect to measure eligible financial assets and liabilities at fair value—under the framework established in FAS 157—and likely will result in some companies electing to measure certain of their assets and liabilities at fair value in the near term.

Unfortunately, fair value has many pitfalls, and I contend that arguments insisting fair value is the “only” value that matters are ill informed, and potentially dangerous. That’s because fair value accounting clearly creates the potential for either unintentional or intentional bias. Fair value models require a number of assumptions, and minor changes can substantially affect the results—companies could significantly manage earnings with slight changes to valuation procedures.

A perfect example of this was covered in an exclusive Compliance Week report on stock option expensing back in May 2006. In the report, Compliance Week analyzed the assumptions used by 50 large public companies for valuing stock options, as required by FAS 123(R), Share-Based Payment. Over a three-year period, the variables those companies employed to value their options fluctuated widely. The companies reported a median 13.1 percent decline in expected volatility, for example, which is one of the assumptions that could lesson the impact of expensing on earnings. Other factors used by those companies in the calculation of fair value, such as interest rate assumptions and term length, also fluctuated. And though some of the assumptions were consistent with what was happening in the market at large—volatility, for example, had indeed dropped in the U.S. equity market—the fact still remains that fair value assumptions are often pliable, and small changes can have a great impact (see "Related Study" in the box at right for the Compliance Week report).

So, is fair value measurement superior to historical cost—particularly now, when every judgment and assumption a company makes is subject to second-guessing by auditors, regulators, the plaintiffs bar, and the press? I wouldn’t guarantee it, especially since the fair value model presumes that management will come up with the “right” number. Ironically, this would obviate the need for the services of the analyst community. If analysts are paid the big bucks to calculate expected market values for companies, and those values are handed to them on a silver platter, who needs the analysts? The answer, of course, is that—in certain instances—analysts know that fair value is not reliable. Which means they will spend their time tearing apart the assumptions used, replacing the numbers with their own models and calculations, which is exactly what they already do today. (So why are we doing this?)

The debate about relevance versus reliability in financial reporting has been going on for years. Many argue if “relevant” information is not “reliable,” then it can’t be truly relevant. At Compliance Week’s annual conference in June 2007, Public Company Accounting Oversight Board Chairman Mark Olson discussed significant issues in auditing fair value, and the difficulty that the PCAOB has in ensuring reliable audits as a result. He noted that for information to be useful to investors it must be both relevant and reliable. He also noted that advocates of fair value accounting maintain that it holds the promise of offering investors more relevant information. Chairman Olson, however, in considering this benefit, noted that we must be mindful that any apparent improvement gained by providing investors with more relevant fair value information will be lost if that information is not also reliable. That’s a critical point, and I hope FASB and the SEC were listening. The SEC has recently formed an “Advisory Committee on Improvements to Financial Reporting,” but I hope that they recognize that a root cause of financial reporting complexity is the move toward fair value accounting. FASB, too, is recognizing the difficulty companies and auditors are having in determining appropriate fair values and have formed a Resource Group to help with the issue.

The PCAOB’s Standing Advisory Group also discussed the difficulty in auditing fair value measurements at its June meeting. The most significant issue, in my opinion, is that accountants are not trained to do it. As Bear Stearns learned the hard way, most companies and audit firms don’t have the technical expertise to properly deal with complex models and estimates to calculate fair value for assets and liabilities with no ready market. While auditors have been dealing with fair value assumptions for some time, their exposure hasn’t been widespread. FASB is increasingly issuing standards before the system—preparers and auditors—are ready to implement them. FAS No. 159, for instance, will become effective for most companies on November 15, and it applies to measurements for stocks, bonds, loans, warranty obligations, and interest rate hedges. So, with our accountants ill equipped to examine these values, what do we think will happen during the audits? Junior level accountants, without the appropriate expertise and skills, will not be in a position to question management’s assumptions about complex thinly traded assets and liabilities.

Sounds a bit like Enron, right?

The use of fair value can also cloud an investor’s ability to evaluate management’s performance. That’s because the model implies perfection in the scope and depth of both the markets and the modeling techniques that, frankly, does not exist. Investor confidence can never be restored under such a model. Relevant information that is unreliable is useless to an investor. We need to be sure that investors recognize that certain fair value information may not be based in any economic reality.

Understandability and comparability are equally as important. What use is a financial statement that is so complex and filled with judgments and assumptions that a reader cannot understand it? How do we ensure that such judgments and assumptions are comparable among companies?

Ultimately, it all comes down to relevancy and reliability.

I can assure you that the investors in the Bear Stearns hedge funds and Enron are not consoled by the fact that the companies they invested in provided more “relevant” information by using fair value accounting.