It is often said in the realm of business valuation that when it comes to conclusions of value that involve exact figures, “reasonable professionals can come to different conclusions using the same facts and circumstances.” To the layperson, this notion might seem rather ridiculous. After all, science and accounting, close cousins to the fields of finance and valuation, are usually concerned with exact numbers and definite solutions. Precision in these disciplines is achieved through thoughtful diligence and careful application of time tested rules. In the field of accounting, the performance and condition of business enterprises have traditionally been presented in historical and present contexts, making precision both possible and highly desirable by users of such analyses.
However, times are changing. Recent events have thrust the discipline of accounting deeply into the domain of finance. This has caused a fair amount of turmoil and confusion. At the center of the issue rests the fundamental premise that finance, as a discipline, is based upon the science of risk and probability. The oft mentioned FAS 157 is based on the concept of mark to market, which in turn functions best when there are liquid markets where the subject interest being measured can experience rapid and objective price discovery. When markets are not liquid, theory must be used in the place of trading information, and it is at this juncture accounting becomes a matter of estimation, not measurement. In making an estimate, one must apply one and sometimes many assumptions, which are introduced into some theoretical framework that ultimately renders a conclusion. These frameworks usually deal with either cross sectional or time series based analysis, meaning they approximate values through the observation of other information available at the time or similar information that has occurred or will occur at different times in the past or future. An example of the former is a pricing matrix, where the yields on bonds of similar credit quality from similar issuers is used to approximate yield and price of the subject bond. Examples of time series based analysis is the discounted cash flow method, where financial information is projected into the future. The approximated value is derived by applying discount rates that incorporate observations regarding the relative risk of the investment.
The problem with these estimates, which generally occur at what is known as Level III under FAS 157, is that they are indeed just that – estimates. What is currently happening is that these “mark to market” estimates are being presented under the old, precision oriented accounting paradigm. In essence they are presented as factual, precise representations of the “intrinsic value” of whatever the relevant asset or liability might be. Investors, auditors, regulators, and lenders alike in turn are relying on these numbers as such. When information is presented that might suggest otherwise, constituents are caught off guard and new figures are developed. This in turn introduces substantial volatility and widespread proclamations of management incompetence and unscrupulous manipulation. Preparers and auditors subsequently point to illiquid markets and unforeseen circumstances as the real culprits. In the past few weeks many have declared that the new mark to market standards are deficient, calling for a return to the tried and true foundations of historical accounting.
I am here to say the move to mark to market accounting is not the problem nor the culprit. The problem is the paradigm needs to shift to suit the new framework. The idea behind mark to market accounting is to improve relevance and reliability of financial information. The accounting of yesteryear is mired in rulesets that are needlessly complex, and I use the term needless because they are still subject to substantial manipulation. Further, the historical cost framework is not flexible enough to keep pace with the velocity of the changes inherent in the evolution from industrial to knowledge economy. Intangible assets and liabilities for example, which are now argued to constitute almost 70 percent of the value of most companies, require valuation approaches that are derived from financial theories, not accounting rules. Merging the accounting systems of all developed and developing countries requires a framework which is flexible and adaptable, yet offers consistency and standardization. The new fair value standards offer all this in spades. The problem is that the standards, even if properly followed, present a portfolio of estimates, not precise representations. The constituents in the accounting community are not used to this.
I propose that when the new fair value standards are implemented in their entirety, the regulatory frameworks require disclosures that adequately communicate the fact that these asset and liability measurements, in the absence of completely liquid and transparent markets that provide real time data as support, are better represented by ranges of values driven by assumptions. The disclosures should be transparent and detailed enough to allow the user of the financial statement to arrive at their own conclusion through the identification and description of the potential effects the critical assumptions have on the estimate. If the old guard wishes to preserve the old financial statement presentation format which is comprised of exact figures, so be it, but footnotes should contain sensitivity tables and monte carlo analyses that clearly outline the impacts of variations in assumptions. Further, the language in financial statements should be adjusted to communicate, clearly and prominently, that the figures presented are the result of estimation, and that other people may arrive at different conclusions given the same information.
I think the consequences of not moving to this paradigm are indeed dire. I would go as far to say the future of the. capital markets depends on it. If, going forward, constituents are led to believe that measurements of mark to market values of illiquid assets are precise, we will see litigation and fraud on an unprecedented scale. The integrity of the financial statement information on which the investor community depends will be severely compromised. As the effects of profound deleveraging and asset devaluation take hold, investor confidence worsens. The migration to fair value, which is being trumpeted as a long run panacea by its proponents, will ultimately be viewed as a failure. The IASB will lose influence and the march towards a global accounting standard will not happen. Consequently, the United States will not receive the level of foreign investment it so desperately needs as a result of a reduction in global liquidity, and the country at serious risk for a protracted downturn.
On the other hand, if the FASB, SEC, IASB, and other regulatory institutions moved to get behind the notion of the estimate paradigm, these pitfalls would be avoided. Volatility would be substantially reduced and investor confidence would be replenished. The change would be welcomed by management and auditors alike, as estimates and ranges would afford companies additional flexibility and legal protections. So let’s not throw the baby out with the bathwater – let fair value take it’s rightful place in the global financial system – but give it its proper introduction.
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