Valuation without rigor = Transparency without clarity

In the aftermath of the 2008-2009 financial crisis, the public demanded politicians and regulators answer two questions: 1) How did the crisis happen? and 2) How can we prevent it from happening again? Globally, the response was to impose new regulation designed to improve the regulators’ ability to monitor investment managers, protect investors and insulate taxpayers from systemic risk.

In analyzing causes of the crisis, commentators and market participants indicted “mark-to-market” or “fair value” accounting as an enabler of misguided lending decisions that became systemic issues. But measuring investments at fair value provides users of financial information, from investors to regulators to policy makers, with a transparent basis of information to make decisions. Although authorities currently seem focused on the broader financial system and on accounting principles and disclosures rather than the underlying valuation, the lesson of the financial crisis should be that fair value accounting is more relevant than ever.

Investors need a consistent basis of reporting value to scrutinize risk, make asset allocation decisions, monitor investments, oversee investment managers, and report financial positions and ongoing performance to their constituencies. Policy makers and regulators need the same level of transparency to monitor systemic risk and evaluate market conditions as they assess the degree of regulation required. Fair value is the common basis of reporting that allows stakeholders to evaluate financial positions on an objective basis.

With the US Congress considering revisions to Dodd-Frank; Brexit in the UK; and the EU’s review of AIFMD, fair value accounting may find itself in the crosshairs. While some easing of the rules may occur as supervisory and government authorities examine the effects–intended and otherwise – of the current regulatory environment, this must not come at the expense of good governance. Indeed, strengthening the mechanics of fair value accounting will help ensure that reported amounts are accurate, reliable and provide the necessary basis for decision making.

Regarding the concerns surrounding fair value: What is fact and what is fiction? Where does suspicion of fair value accounting begin and trust in fair value judgements end? Unfortunately, there is still a great deal of misinformation and misunderstanding surrounding the concept of fair value. Fair value is, “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” So why do these simple words still create so much debate?

As we saw during the financial crisis, valuing assets–especially illiquid assets–requires significant informed judgement. Bankers often question the need for fair value; negative interest rates highlight dislocation in the value of expected cash flows; and variables like climate change are just beginning to enter the valuation discussion. While global fair value accounting standards have converged around the definition of fair value, it is undeniable that questions remain about how best to estimate and use fair value consistently, particularly with respect to alternative assets.

Consequently, the valuation profession is in the process of implementing expanded frameworks to ensure that value is estimated and reported with sufficient rigor and is of the highest quality. The new Certification in Entity and Intangible Valuation (CEIV) in the US, combined with International Valuation Standards (IVS) now being applied on a global basis, should help mitigate some of the above issues. By implementing and strengthening valuation frameworks globally, the valuation profession reinforces its operating principle that fair value is the best basis to measure and disclose investment assets even though judgment in valuing such assets will always be a necessary variable.

For the sake of the global economy, it is vital that the strides made in strengthening fair value accounting in the last decade are not undermined in a global environment that is challenging the reach of regulation. Further, new information, such as measuring environmental, social and governance effects, also needs to be objectively considered using a common basis of underlying analysis. A rigorous valuation framework must consider the potential impact of climate change, energy policy and other macro issues that will arise in the future.

As the G7 contemplates the future, efforts need to be taken to ensure that the established fair value framework is retained and enhanced so that investable assets are measured on a consistent basis that provides transparency to all parties involved. A dynamic, robust global valuation framework ensures that accurate information is available to make vital decisions that will allow the world to prosper and to avoid past mistakes.