Accounting

Is It Fair to Blame Fair Value Accounting for the Financial Crisis?

Investors and corporate executives don’t agree on how to value distressed assets. But maybe they don’t have to.

by

Robert C. Pozen

by

Robert C. Pozen

From the Magazine (November 2009)

Summary.

Reprint: R0911G

When the credit markets seized up in 2008, many heaped blame on “mark to market” accounting rules, which require banks to write down their troubled assets to the prices they’d fetch if sold on the open market—at the time, next to nothing. Recording those assets below their “true” value, critics argued, drove financial institutions toward insolvency. Proponents of marking to market, on the other hand, said it exposed executives’ bad decisions. If not for this fair value accounting practice, investors would be kept in the dark about the banks’ real state of affairs.

In this article, Pozen, the chairman of MFS Investment Management, dispels the myths about fair value accounting. For example, it’s untrue that most bank assets are marked to market—in 2008 just a third were. Not all write-downs reduce the banks’ regulatory capital. Nor is it true that under historical cost accounting, companies don’t have to acknowledge changes in market value; they’re required to record permanent impairments to assets.

After explaining the controversy, Pozen proposes a solution: new, transparent practices that would draw on the best of both historical cost and fair value accounting. If adopted, they could balance the banks’ desire to present assets in a good light with investors’ need to understand the banks’ exposures—and perhaps make everyone happy.

The Idea in Brief

• A battle is raging about whether assets should be “marked to market” in quarterly financial statements, as opposed to reported at historical cost. Some executives blame marking to market, which is generally advocated by investors, for the financial meltdown.

• Myths are being propagated by both sides in the argument. But it’s not true that historical cost accounting can disregard permanent changes in current market value or that most assets of financial institutions are marked to market.

• Solutions that serve everyone’s needs are possible. If accounting and capital requirements were substantially unlinked, marking to market would not usually have a negative impact on a bank’s regulatory capital. Income volatility would be better understood if banks published two EPS figures—one with assets recorded at fair value and the other without. And the fair value accounting approach of “marking to model” could gain some credibility with investors if they were given the assumptions underlying these models.

What was the primary cause of the current financial crisis? Subprime mortgages, credit default swaps, or excessive debt? None of those, says Steve Forbes, chairman of Forbes Media and sometime political candidate. In his view, mark-to-market accounting was “the principal reason” that the U.S. financial system melted down in 2008.

A version of this article appeared in the November 2009 issue of Harvard Business Review.

A former president of Fidelity Investments, Robert C. Pozen is a senior lecturer at MIT’s Sloan School of Management in Cambridge, Massachusetts, and a nonresident senior fellow at the Brookings Institution. He is the co-author of Remote, Inc.: How to Thrive at Work…Wherever You Are (with Alexandra Samuel).

Is It Fair to Blame Fair Value Accounting for the Financial Crisis?

The Idea in Brief

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