NEW YORK (Reuters) - Some investors are starting to question an accounting method used to put a market value on hard-to-price assets as the credit crunch has caused their markets to evaporate.
Over the past few years, an ever-larger number of U.S. accounting standards has required companies to use mark-to-market, or fair value, accounting. The push was touted as a way to boost transparency for investors.
But as companies like Citigroup Inc (C.N) and Merrill Lynch & Co Inc MER.N post multibillion-dollar write-downs on subprime-related asset-backed securities and other hard-to-price assets, some investors say fair value is not worth the earnings volatility it causes.
"It's ridiculous to apply fair value accounting to assets that have no market," said Christopher Whalen, managing director of risk research firm Institutional Risk Analytics. "All this volatility we now have in reporting and disclosure, it's just absolute madness."
Most financial reporting had been based on historical cost, which is the original price paid for an asset. But U.S. accounting rule makers have come to view fair value, or the price the asset could fetch in the current market, as more transparent.
Critics say fair value does provide a realistic view when price quotes are readily available, but when there is no market, or a market disappears as it did in the credit crunch, companies must use complex mathematical models to come up with values that can be just as confusing to investors.
"All these write-offs aren't real losses; they're just mark to market," said Stephen Ross, chief executive of Related Cos, one of the largest U.S. real estate developers.
"(The banks) are being forced to take those losses because accountants have to give them a clean opinion," Ross told the Reuters Housing Summit last week.
Accounting rule FAS 157, which for most companies takes effect this year, requires a specific fair value framework to value most financial assets, but some believe fair value, and the early adoption of that rule by most financial firms, has exaggerated write-downs tied to the credit crunch.
"It breeds overpessimism," Whalen said. "Most of the losses reported by the banks were noncash. The only people who benefit from this are the hedge funds, who make money off volatility."
For years, critics of fair value have argued that the resultant volatility reduces stock prices, but its proponents say it reveals economic realities that were hidden by previous accounting methods.
"Would you rather they come up with a model and say we think it's worth $60, but yet no one would buy it unless it was at $40?" Financial Accounting Standards Board Chairman Robert Herz told Reuters earlier this month.
Investor groups, in fact, are among those that have aggressively lobbied for more use of fair value in financials. In a 2007 report, the CFA Centre for Financial Market Integrity, which represents analysts and portfolio managers, said it believed fair value provided the most relevant information for financial decision-making.
Others say the extent of the banks' write-downs may just have taken investors by surprise.
"Investors as a group have to get a better understanding of what the volatility means," said Ed Nusbaum, chief executive of accounting firm Grant Thornton. "They want to live in a perfect world. They'd like complete transparency and no surprises. But I think it's unlikely that the big write-downs that we've seen will reverse."
Others, however, say that if the credit markets recover, banks' earnings would rise and the write-downs would reverse.
"Some would argue that creating this kind of volatility in financial information is too much," said Michael Young, a securities lawyer at Willkie Farr & Gallagher in New York. "The other argument is that life is volatile. Part of transparency is letting people see what's really happening."
Editing by Leslie Gevirtz and Lisa Von Ahn