Is Fair Market Fair?
Is fair market fair? Should assets be marked to market or should they be left at historical cost? Perhaps the most reliable, relevant, and comparable financial statements would result from allowing for both historical cost and fair value accounting to continue. Through interpreting the Financial Accounting Standards Board’s (FASB) fair value measurements reasons can be provided why the best approach might come from companies mark to marketing level one and level two assets and reporting level three assets at historical cost.
The Financial Accounting Standards Board created a fair value measurement to provide guidelines on how assets are to be estimated by categorizing these assets into three levels. Level one items are liquid assets with an active market of identical assets at quoted prices. Examples of level one assets and liabilities are US government and agency securities, foreign government debt, listed equities and money market securities (Patching 2). These valuations have strong evidence to prove their reliability, thus should be marked to market. Level two assets and liabilities are estimated by quoted prices of similar assets and liabilities on an observable market. Examples of level two assets and liabilities are corporate bonds (investment grade, high yield), mortgage-backed securities, bank loans, loan commitments, less liquid listed equities, municipal bonds and certain OTC derivatives (Patching 2). These valuations are not as reliable as level one assets because level two assets are estimated, but because there is an active market for similar assets there is strong evidence to prove that these estimations are accurate. Level three assets, which are commonly referred as “mark to myth” or “mark to make believe,” is the third category. Examples of level three assets and liabilities are distressed debt, private equity, exotic or non-standard derivatives (Patching 3). These items are the most difficult to estimate simple because there is no market to which prices can be compared to. These assets are estimated by managers of a company based on the internal information of that company (McGladrey & Pullen LLP 1-2). To value these assets, companies are forced to estimate a selling price for assets that they do not want to sell on a market where no one wants to buy. Estimating these valuations is rather difficult and costly to companies.
To enforce mark to market accounting of level three assets is unfair because the cost is high to companies. For example, if an asset was bought for $100,000 any C.P.A. would determine that price is the historical cost. If one hundred appraisers were asked to value an asset, most likely they would be able to and would likely come up with one hundred different answers. Appraisals of level one and level two assets would have a close mean, but level three items will tend to have much higher variances of opinion. The cost to get these level three assets appraised and audited is also higher because the valuation technique required by the FASB is more controversial then valuing level one and level two assets. Because the only information for these level three assets comes from the company, auditors spend more billing time investigating the information provided by the companies and calculating their own estimation. This makes companies spend more money to get less reliable information. The Sarbanes Oxley Act has already increased the cost to companies to report financial statements and made it more difficult for start-up companies to make an initial price offering. Forcing companies to mark to market these costly level three items would make the barrier to entry into a publically traded company even higher. Mark to marketing level one and level two assets are more objective, reliable, and cost-efficient. In an article written by Mr. Reuters of CNBC, Colin Martin, a partner at KMPG's FS Technical Advisory states, “If there is a price out there, it cannot be ignored…It is very difficult to overcome an actual price,” He continued, “You have to find some other evidence why that price is not valid” (Reuters 2). Since there are prices on the market for these level one and level two assets, they should be reported at their fair market. However, the cost to value a level three asset at its fair market value far exceeds the benefit of having these controversial estimates on the books.
Fair marketing level three assets is unfair to entities because companies are required to write down assets to fire-sale prices. For example, there are two companies in the same industry, one is near bankruptcy and must sell their assets. Since there is no demand for these assets their selling price would be extremely low. The second company must determine the fair value of their similar assets each quarter. In an area where there is no market the only market values would be where company one was required to sell their assets at a distressed price. Company two would then have to write down their similar assets to these fire-sale prices. This unfairly lowers the value of companies that are doing well to the value of companies that are going bankrupt. Estimating fair value of level three items also creates a conflict of interest.
Level three assets are values estimated by top management of companies based on internal information. Allowing Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs) of corporations to estimate their own assets is not fair to investors. During an interview with Becky Quick on CNBC’s Squawk Box Warren Buffet stated,
I've always been theological on mark-to-market accounting, because I've seen so much of what people do when they're allowed to use their imagination on balance sheets or income statements. And frankly, American business misbehaved in a big way, particularly in the '90s. But people did play games with numbers. And they probably still do. But it--there was--it was almost accepted as a way of doing business. So I've always been suspicious when you give a CEO a pen and tell him it's the honor system (Quick 11).
It is daunting to hear Warren Buffet say that people use their imaginations on income statements, but when CEOs estimate assets based on internal information they have that ability. Top management’s performance is evaluated based on the financial statements they produce at the end of the year and then they are given bonuses based on those financial statements. This creates a conflict of interest because instead of focusing on providing the most reliable financials, CEOs and CFOs benefit from inflated assets and understated liabilities.
Allowing management to estimate their own assets gives them too much influence over the financial statements. CEOs and CFOs having more control over their financials weakens the confidence of the investors. Investors with little belief in the financial market ultimately results in a contracting economy. Investor’s confidence is currently very low from scandalous top management frauds such as the ponzi scam of Bernard Madoff, financial statement fraud of Enron, and executive theft of Tyco. Instead of giving managements more power, the SEC should be limiting their influents to restore investor’s confidence and boost the economy. By not allowing CEOs to use internal information to estimate their assets and reporting these items at historical cost the power to influence their books would be taken away from management. Even though this information might not be the most accurate, the strengths and weaknesses of historical cost should be acceptable to insure reliable and honest accounting.
Fair market value is a great tool to report accurate financial statements as long as the information is reliable. FASB created a far value hierarchy which breaks up valuations into three levels. Levels one and two items are based on prices observed from the market. Level three items are assumptions for valuations based on information from within a company. Forcing level three assets to be marked to market is very costly, requires assets valuations at fire-sale prices, creates a conflict of interest and gives management too much control of their financials. To be fair to companies and investors alike, level one and level two assets should be marked to market and level three assets should be left at historical cost.
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Article Source: ArticlesBase.com - Is Fair Market Fair?