Fair value falls apart

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The International Accounting Standards Board IFRS project seems to be falling apart at the seems. Like so much of the current financial architecture, International Financial Reporting Standards have been tested only in an upside to date.

Now I'm far from saying we have a down side right now, but we have had it in the financial markets. The value of the debt of some companies, and especially banks, has fallen. But amazingly this has gives rise to profit in their accounts because debt (what you owe people) is priced at 'fair value' in your accounts, which is what it is worth in the market place,

Now suppose you have debt of $2 billion on your balance sheet, but your rating goes down because it is perceived that you are a risker organisation. The price people will now pay for your debt (and remember, debt is traded) has fallen. Let's suppose the fall is 5%. That reduces the value of your debt to $1.9 billion. In accounting terms under IFRS this has to be reflected in your balance sheet. The fair value of a liability (what you owe) has fallen. Liabilities are credits on your balance sheet. So you debit your liability account with $100 million. This cuts the value of the debt.

But now you have the job of 'losing' the credit in your accounts because in accountancy there is an immutable rule that for every debit there must be a credit. You can't, of course, put it back on the balance sheet. You've just taken it off that. And it's not cash so it can't appear in the cash flow. And nor is it a reserves movement because it is a result of current activity. So there's only one place left to put it, which is in the profit and loss account.

There's one problem though. On the balance sheet this credit represented a sum owing to someone else. It was a debt. By and large debt is seen as a negative in accounting even though it is a credit because it owed. In the profit and loss account though credits are quite different. Credits are good things in the profit and loss account. They are sales or cost reductions. And that's exactly how this credit of $100 million behaves when it hits the profit and loss account. It goes straight to the bottom line and increases the profit for the period.

You don't believe me? This hit the FT yesterday. And the Wall Street Journal. In fact I'll go on record as being at one for the first time I can ever recall with the American Enterprise Institute on this one when one of their fellows said in the FT:

We learn from "Lehman results bring cheer to Wall Street" (September 19) that Lehman improved its reported profits because of new accounting rules "allowing it to book as profits the reduction in value of some of its debt".

In other words, if the "fair market value" of your debt goes down - perhaps because the bond market considers you a worse credit risk - while you owe exactly the same amounts to your creditors as you always have, you can then declare a "profit". The "fair value" accounting theorists have thereby arrived at absurdity.

That's true. It has. When you get make money by seeing your credit rating fall you know that accounts are not showing a true and fair view.

It's time to say goodbye to this nonsense.