Charles Lee: Why Fair-Value Accounting Isn’t Fair

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Enron executive Sherron Watkins, left, who objected to a type of fair-value accounting used by the company, looks on in 2002 as former Enron CEO Jeffrey Skilling testifies on Capitol Hill. | Associated Press photo by Kenneth Lambert

During the darkest days of the financial crisis, banks came under scathing criticism for using traditional accounting practices to minimize their massive losses tied to junk mortgages.

The culprit, according to many financial reformers, was the practice of valuing financial assets on the basis of their historical cost. Even if subprime borrowers were still paying on time, the critics said, their mortgages and the securities backed by them had become almost worthless on the open market. Nobody wanted to buy them. To the critics, the banks were pretending that their capital was still strong when much of it had been wiped out.

To promote transparency, reformers have pushed banks and all other companies to embrace “fair-value” accounting – valuing assets on the basis of the current price they would fetch if they were put up for sale. It’s not just an issue for mortgage loans and bank balance sheets. Supporters of fair-value accounting would apply it to most other tradable assets, even patents.

Charles Lee, professor of accounting at Stanford Graduate School of Business, begs to disagree.

Fair-value accounting, he argues, goes against the fundamental purpose of accounting. It would actually inject more uncertainty into financial reporting and make life harder for shareholders. It might even create new opportunities for companies to cook their books.

In a combative keynote address at a London accounting conference last December, Lee argued that fair-value accounting confounds and confuses the core purpose of rigorous accounting. That purpose, he contends, is to provide economic history — an accurate report on transactions that have already occurred.

Market-value assessments represent something entirely different: collective forecasts about future returns. They embody the combined judgment of investors, buyers, and sellers about future cash flows, future growth, and future economic conditions.

Lee isn’t disparaging market valuations. In fact, he argues that the most important component of a company’s market value lies in shareholder expectations about its future earnings. But the purpose of accounting isn’t to make those forecasts, he insists. The purpose is to give shareholders the tools they need to make their own forecasts.

“The market has come to rely on accountants as the keepers of economic history,” Lee declares. “As an investor, when I turn to financial statements, I want a trustworthy and interpretable account of what took place. As soon as we start to anticipate future exchanges, we are in a world of speculation. And unfortunately, given dysfunctional managerial incentives and other moral hazard problems, it is often a world of fiction.”

If one were to take the logic of fair-value accounting to the limit, Lee warns, why should investors even bother trying to measure earnings according to generally accepted accounting principles (GAAP)? Why not just report a company’s stock return in its annual reports and let the market take care of the rest?

Lee notes that shares of Apple Inc. plunged during 2013, even as the stock market was surging and even though the company reported its highest sales ever. Apple’s CEO, Tim Cook, insisted that the company had an “amazing” year, but investors were gloomy about its future. (Apple shares roared back in 2014.)

“Whose view better captures what happened to Apple in 2013?” Lee asks. “And whose view should be reflected in Apple’s GAAP financials?”

But what about the banks, which kept all those unsellable mortgage securities on their books at values far higher than they would ever have sold for during the financial crisis? The stock market’s judgment about Lehman Brothers was a much better guide to its fate than Lehman’s official balance sheet.

Lee doesn’t cede an inch on this. If anything, he says, current market values are even less reliable in a crisis, because panic dominates and nobody wants to buy anything.

“The mortgage crisis was a very unusual situation, because the market had frozen up entirely,” Lee said in a recent interview. “Under those types of settings it is very difficult to know what the fair market value of something should be. The idea of fair-value accounting is that you’re marking your asset to the price it would receive in the marketplace in a fair and orderly liquidation. But what does that mean if every bank in the market wants to sell?”

“Fair-value accounting has this wonderful seductive appeal, because that’s what the world thinks an asset is worth,” he continued. “People think market value is Truth with a Capital T. But it’s not.”

Indeed, there is at least one notorious case in which fair-value accounting was used as a tool of corporate fraud: the collapse of Enron Corp. Top executives at the energy-trading giant insisted on using fair-value accounting to artificially inflate the value of many of its energy-delivery contracts. The maneuvers have been detailed in books (see Power Failure: The Inside Story of the Enron Collapse) as well as in scholarly papers. Over the objections of Sherron Watkins, an Enron finance executive who later became a key whistleblower, the company used what is known as a “Level 3” approach to fair-value accounting. “Level 3” is a set of principles for determining the “market” value of assets in which there is no trading and hence no market. The company relies instead on internal assumptions to estimate what prices would have been if there had been a market.

Lee is quick to caution that he is not arguing that fair-value accounting is inherently corrupt. “I think that many of my colleagues who support fair value sincerely believe they are taking the high road,” he says.

Nevertheless, he adds, Enron provides a vivid example of how fair-value accounting is hardly free from the kind of manipulation that critics have associated with historical-cost approaches. And while machinations over “Level 3” aren’t what ordinary people associate with fair-value accounting, that approach is permissible and reflects the goal of applying current “market” values wherever possible.

Lee doesn’t dispute that historical-cost accounting also has its flaws, or that corporations can try to game that system.

But he says the proponents of fair value miss the point of accounting, especially for the purpose of helping shareholders divine truth. The “book value” of a company – its assets minus its liabilities – should almost always be lower than the company’s market value. That’s because a healthy company is worth more than the sum of its parts. It is an ongoing enterprise that generates extra returns from its assets.

The exact valuation of a company’s assets is less important than the consistency in how those values are reported. That’s what allows investors to judge whether a company is expanding or contracting from one year to the next. The role of accounting, Lee says, is to provide a common “language” and consistent set of reporting rules that everybody understands in the same way.

Adding in the educated guesswork embodied in market valuations of a company’s assets simply bakes more uncertainty into the numbers. That makes forecasting even more difficult than it already is.

“Accounting provides investors with a language and tools to make their own forecasts of future earnings growth,” Lee says. “Most of the fair-value stuff isn’t going to help them. In fact, it’s going to screw them up.”

Charles M.C. Lee is Joseph McDonald Professor of Accounting at Stanford Graduate School of Business.