Unfair value accounting

Fair value accounting has been discussed widely recently and deserves comment from a free market advocate. First off, having confidence in free markets is not the same as thinking market values represent useful information. Useful and transparent information is the purpose of attempting to implement fair value accounting. Seems reasonable, however there are several inherent flaws.

Unfortunately markets are not efficient in the short term i.e. the measurement date used for financial reporting. These short term inefficiencies when interpreted as fair value can cause unnecessary volatility in firm’s balance sheets and reek havoc with the slightest amount of leverage. Warren Buffet uses the analogy that if you buy a farm, you don’t hire an appraiser to come out every day an tell you what it’s worth. Just because the market produces a price on a measurement date does not mean they are producing a reasonable value. By definition, a market is only capturing data from a few of the parties involved in a particular asset. The transaction is taking place between two parties who believe they are benefiting from a favorable price, that’s why they are making the transaction to begin with. What the market price does not consider is all of the parties that are not able to come to an agreement, because their perceptions of value are too far apart for the particular asset. Fair value accounting is in essence forcing these two holdout parties to accept the price set by the transactions and reflect that on their balance sheet.

What is the value of an asset that currently has a market price $70 and a 5% dividend? Under traditional valuation methods, this assets value would be some discounted factor of the future dividend income and a projected sale price. Using fair value accounting, the asset would be valued at the market price. The market has valued the following assets at $70 or more in the past year: Bear Sterns, Fannie Mae, Freddie Mac, Lehman Brothers, Ambac, AIG, etc… Fact is the market was dead wrong on every one of these firms and was extremely inefficient in the short term.