CFO.com’s article, Bearing It All: The perils of derivatives and fair-value accounting is depressing. It uses problems at Bear Stearns to illustrate some of the complexities in arriving at fair values for derivative instruments. The article is depressing because to my mind at least, it doesn’t attack the root cause issue. While acknowledging the problems, it doesn’t provide a satisfactory answer, concluding that:
Fair value is perhaps most worrying for auditors, who are often blamed for faulty accounts. Faced with murky models, the best they can do is examine assumptions and ensure disclosure. Mark Olson, chairman of the Public Company Accounting Oversight Board, a regulator, expressed his unease last month. “Valuation requires training,” he said, “and many auditors may not have extensive training.” Investors, in other words, are on their own.
I disagee. Those who remember the ill-fated IR39 will know that is was heavily amended largely because auditors understood the valuation problems. I spoke at a number of meetings on this issue. My concern was there were significant implications from an IT audit perspective that I considered to be wholly irreconcilable with rational judgment. Nothing has changed.
To put it bluntly, derivatives are little better than complex casino bets. It doesn’t take much thinking to realise that under the prudence rule, a bet has no value. The way IR39 was phrased, auditors would have been forced to make all sorts of assumptions, coming up with opinions that could be wildly inaccurate yet readily defensible. No-one wants to be in that position, not because it is dodging the issue but because it violates the certainty rule.
I believe this issue could be readily solved by simply declaring that derivatives have no intrinsic value under the prudence rule, citing Bear Stearns experience as a proof. That will thoroughly annoy financial gamblers but it recognises the significant risks that derivatives represent. Having said that, Bob Herz, chairman of the AFASB thinks this is wrong. From the same CFO article:
Unfortunately, the alternatives to fair-value accounting can be worse. Historic cost may be harder to manipulate than the results of a model. But as Bob Herz, chairman of America’s Financial Accounting Standards Board, points out, it too is “replete with all sorts of guesses”, such as depreciation rates. And for derivatives, historic cost accounting is patently wrong. The historic cost of employee stock options, for instance, is zero.
This is myopic thinking. It mixes apples and oranges. A stock option is completely different to a derivative bet so making that comparison and then implying a fall back is wrong. This is about testing the nature of different asset classes for the purpose of arriving at fair value.
The innovation here? Application of the KISS rule.
ENDNOTE: Note Bear Stearns workaround. IMO, the worst of all worlds.
Technorati Tags: audit, innovation, fair value
