by Terry Rice

Created on: November 03, 2007   Last Updated: November 05, 2007

Accountants Failing Investors With Fair Value' Accounting

If anyone thinks the accounting profession has learned anything following the Enron experience, they haven't spent much time thinking about the topic of "Fair Value Accounting". The beginning of the end for Enron was the company's penchant for manipulating fair value calculations to its advantage. Fair value has taken the conservatism out of accounting and made numbers less reliable.

There is a fierce battle raging in the accounting world over the use of fair value. Courtesy of the credit crunch, the argument has escaped into the wider business world, as investors and others grapple with the problems of valuing illiquid securities. This is the second time in seven years that widespread problems have arisen in US accounting, securities ratings and governance. Despite the onerous and costly requirements of Sarbanes-Oxley, and stringent audit controls, the system was unable to fix something as basic as the existence and collectibility of loans.

International and US accounting rules typically demand that fixed assets are valued at cost and subject to periodic impairment tests. Financial assets, however, are usually carried at "fair value" the price a third party would pay for them. Under these rules, financial instruments (including mortgage-backed securities) are stated on balance sheets at their "fair" values, which are taken from markets where possible, or for more complex securities are estimated from valuation models. There is no perfect valuation model. It is extremely difficult to value assets that do not have a ready liquid market. Fair value for financial instruments means exit or sale price, which should in theory be equivalent to market value. Since mortgage-backed securities are not frequently traded, the "fair value" is difficult to determine.

Unfortunately, fair value has many pitfalls. 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. The results of these models can vary enormously, depending not only on what the "inputs" might be but also on the actual models that are used.

The most significant issue is that accountants are not trained in fair value measurements. Most accountants don't have the technical expertise to properly deal with complex

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