Fair, but for whom?

On the surface, there is nothing to dislike about such a statement. ‘True’ and ‘fair’ are effectively synonymous – it would not be possible for a set of accounts to be untrue and fair. So, in effect, the only word that matters is ‘fair’ – a company’s accounts are judged to be ‘fair’. And that’s where we start to encounter complications.

In accounting, ‘fair’ often means ‘fair value’ and fair-value accounting often equals ‘mark-to-market’ accounting, which basically means what it says. In other words, the value of assets and liabilities in a company’s accounts are stated at a market value, an up-to-date value that is derived either from an active market of buyers and sellers or, in theory, from an acceptable proxy. 

The alternative is to use historic-cost accounting, which, again, pretty much means what it says – assets and liabilities are shown in the accounts at the amounts originally paid (or received, in the case of liabilities) and are progressively written down by an allowance for depreciation. That’s fine, so far as it goes. Historic-cost accounting specifies how much capital was committed to specific assets and, therefore, how much capital was committed in total, which, for users of accounts, can be useful to know. But its shortcoming is that it offers no clue as to when particular lumps of capital were committed. That’s unhelpful because, say, £1m committed 10 years ago would be a more significant outlay than £1m committed last year. What it ends up producing is a historical mish-mash of figures that bears little or no relation to current reality. 

So, given the blunt (and biased) choice, how do you want your accounts, historic-cost and meaningless or fair value and really helpful, there is really only going to be one answer. Until, that is, someone mutters the infernal word, “Enron”. That’s because the affair of Texas-based energy trader Enron was arguably capitalism’s worst scandal of the past 50 years – and it was built around fair-value accounting. 

In 1985 Enron was born from the merger of two struggling utilities companies, Houston Natural Gas and InterNorth, a gas pipeline operator. A combination of debt from its merger and the de-regulation of the US gas-supply market meant that Enron needed to do something smart to survive. Enter Jeffrey Skilling, the malign genius who would transform Enron into a $70bn company first by creating a ‘gas bank’, an energy trader that bought gas from a network of suppliers and sold it to users on long-term contracts. What worked for gas also worked for electricity and was soon applied to a variety of other services. So much so that, at its crazy worst, Enron took profits upfront from a long-term deal with Blockbuster to provide videos on demand to customers who, at that time, did not exist via the internet bandwidth that it would buy as and when.

But arguably the smartest move Mr Skilling made was in January 1992 when he persuaded the US Securities and Exchange Commission, that country’s securities industry regulator, that Enron could use mark-to-market accounting to value those long-term contracts. 

The effect was to manufacture instant and huge accounting profits because the fair value of Enron’s multi-year contracts was the estimated net present value (NPV) of revenues to be received which – of course – was greater than the present value of the costs of supply. Enron piled on the contracts amid a corporate culture that encouraged any deal so long as it could show a positive NPV. As a result, its profits surged and its share price surged even more. Its shareholders got rich, its employees got rich, Mr Skilling and Enron’s bosses got richer still. For a while, everyone was happy. 

Naturally, it all fell apart. It was one thing to conjure paper profits by aggressive selling and fair-value accounting – or accounting for “price risk management assets”, as Enron called it. It was quite another to generate positive cash flow. In a belated effort to bridge the burgeoning gap between accounting profits and cash losses, Enron went from creative accounting to fraud as it used so-called ‘special-purpose entities’ – short-life off-balance-sheet vehicles – to fake cash coming into the group. 

The game was pretty well up in April 2001 when, in a meeting for securities’ analysts, one analyst said of Enron’s accounts, “the notes don’t make sense and we read notes for a living” only to be met with a string of expletives from Mr Skilling. By November that year, Enron’s share price, which had peaked at $90.56 in August 2000, closed for the final time at $0.26. A few days later the company filed for bankruptcy. In 2006, Mr Skilling was sentenced to 24 years in prison on various felony offences. On appeal, this was cut to 14 years and, last February, he was released, having served 12 years. 

Granted, many factors lay behind Enron’s rise and fall. But, arguably, the stand-out cause – the one without which its rise would not have been possible – was its use of fair-value accounting. Yet focus in on that issue and we can see that Enron was not really using mark-to-market accounting. It is closer to the truth to say it was using ‘mark-to-estimate’ accounting since there was no question – and, on Enron’s part, no pretence – that it was using data from liquid, transparent markets to value its contracts. Rather, it was using so-called ‘unobservable inputs’, which were derived who knows how, to come up with convenient figures. 

A big concern is that unobservable inputs, much like those that Enron employed, are still used in the fair-value accounting standards that have been written since both the Enron scandal and the US sub-prime mortgage crisis of 2008-09, which was exacerbated by mark-to-market practices. 

No matter, has been the response of the accounting-standards setters – the UK-based International Accounting Standards Board (IASB) and its US counterpart, the Financial Accounting Standards Board – the solution lies not in less fair-value accounting, but more of it, and better. The standards setters rightly point out that there can be an information gap between what a company’s bosses know about their company’s state of affairs and what interested outsiders, especially shareholders, know. This information asymmetry is best solved by fair-value accounting. As Sir David Tweedie, the chairman of the IASB for its first 10 years until 2011, said following Enron’s collapse: “The current direction we are taking is what I like to label ‘tell it like it is’ accounting. This may mean increasing reliance on fair values.” 

True, Sir David did add the rider about fair values, “when those values can be determined accurately”. Arguably, however, that is something that today’s accounting standards for fair value achieve only in parts. 

For UK companies, those standards are chiefly IFRS 13 – Fair Value Measurements and IFRS 9 – Financial Instruments. The two standards overlap. IFRS 13, which was completed in 2011 and came into force for accounts beginning on or after 1 January 2013, defines fair value and sets out the framework for measuring it. IFRS 9 had a much longer gestation and was completed in 2014 to apply to accounts beginning on or after the start of 2018. It specifies how companies should treat changes in the fair value of financial assets and financial liabilities in their accounts. As such, it is closely concerned with valuing the assets and liabilities found on banks’ balance sheets. Thus its progress got bogged down in the fall-out from the sub-prime mortgage crisis. 

From an investor’s view point, there are two big demands that these accounting standards make on companies: 

1 How to assess and to quantify fair value;

2 How to apply changes in fair value to the accounts

Assessing and quantifying is chiefly the task of IFRS 13, which tells companies how to measure fair value, but not when to measure it. To use its own jargon, the standard revolves around a “fair-value hierarchy”, which assigns a company’s assets and liabilities (let’s focus on assets because they are easier to grasp) to one of three levels, whose fair value we can caricature as ‘good’, ‘acceptable’ and ‘iffy’. 

Level 1 – good – is for fair value based on the quoted selling price of an identical asset traded in an active market. Thus, if a company holds shares in a listed company, the fair value of its investment would be the market’s bid price for the same stock at the balance-sheet make-up date times the number of shares held – obvious really. 

Level 2 – acceptable – is where fair value is the same as level 1 except that it is based on an identical asset that only trades in inactive markets, or where the value of, say, security A is derived from the value of security B, which has similar characteristics to A and trades in an active market. Alternatively, level 2 fair value might be derived from market interest rates or yield curves, which will especially apply to fixed-interest investments. 

Level 3 – iffy – is where there is no market, active or inactive, to help. That’s when companies employ ‘unobservable’ inputs, which means they are likely to use their own data. In this context, a company “need not undertake exhaustive efforts to obtain information about market participant assumptions,” says the standard, but it should take into account all the market-related information that is “reasonably available”. To which the cynical response would be, “yes, much as Enron did”. 

Overlapping this hierarchy of fair value come clear instructions on the valuation techniques used to find the values. These fall under two headings – the market approach and the income approach. The market approach pretty well follows on from the requirements of levels 1 and 2, deriving its value from the selling prices of identical assets or from the earnings multiples at which comparable companies are rated in the market. The income approach, which applies to level 3, is straightforward investment-valuation stuff, using tools such as the net present value of future cash flows or dividend discount models to come up with fair-value estimates that should – give or take – reflect the known risks and uncertainties. 

Telling companies how to apply the initial measurement and subsequent changes in the fair value of – mostly – financial assets and financial liabilities is the job of IFRS 9. It offers three ways – a company can either show changes in amortised cost through its income statement; changes in fair value through other comprehensive income, which is a subsidiary part of the income statement; or changes in fair value through profit and loss, which contributes towards pre-tax profit. 

The choice will depend on the purpose for which a company holds an asset. Changes in amortised cost will be used by those companies, almost all of which operate in the financial sector, that hold financial assets as part of their regular business activities – most obviously, a bank holding a loan. However, financial companies that hold financial assets to buy and to sell, as well as for their cash flows, would account for changes through other comprehensive income. That leaves financial assets that are held for any other reason; fair-value changes in these are taken through profit and loss. 

For finance-sector companies, it is still early days for IFRS 9. So, for example, business and consumer lender Secure Trust Bank (STB) adopted the standard for its 2018 figures without re-stating the previous year and noted that it “is a more volatile methodology compared to the previous (standard). Changes in the performance of underlying loan balances are more immediately reflected in the required IFRS 9 impairment charge”. 

That was good for Secure Trust’s 2018 figures since it meant that impairments in the firm’s motor-finance lending book were lower than the previous year even though the book almost doubled to £276m. Similarly, group-wide, impairment losses fell from £33.5m to £32.4m even though loans rose from £1.57bn to £1.98bn. However, what applies on the upside applies to the downside too, and Secure Trust warns that deteriorating performance would have an immediate impact on profits. 

Meanwhile, what we might label a routine application of fair-value accounting is shown in Table 1, which is extracted from the latest accounts of Associated British Foods. By far the biggest item is the £65m write-down of the company’s investment in its Allied Bakeries subsidiary. This was a so-called level-3 adjustment since putting an up-to-date value on the maker of the Kingsmill, Sunblest and Allinson brands is based on unobservable inputs. Yet management’s description sounds like a fairly conventional valuation, where future cash flows based on assumptions for prices and volumes in the UK bread market, combined with the effect of possible cost savings, were discounted to present value using a fat and risk-averse interest rate of 10.9 per cent. 

The accounts offer no background to the fair-value write-down of acquired inventory; ditto the gains and losses on financial assets, which actually include assets as non-financial as payments owed by customers. No matter, these items account for just 1 per cent of operating profits before adjustments in both 2017-18 and 2018-19 and they will be a recurring item at a group as big as AB Foods; as such, they are barely material.

Materiality, however, bursts from the fair-value gains recorded by Burford Capital (BUR), an Aim-quoted Guernsey-headquartered company whose role is to provide the finance for civil litigations and take a slice of the settlements. As Table 2 shows, in 2015 Burford’s fair-value gains were a comparatively-modest $22m out of $77m operating profits, or 29 per cent. By 2018, such gains contributed $230m out of $344m of operating profits, 67 per cent of a much bigger total. 

The basic concerns are twofold. First, Burford’s fair-value gains stem from level-3 valuation methods at their most unobservable. As Burford itself says about valuing the possible pay-offs from legal cases, “the estimation of fair value is inherently uncertain. Awards and settlements are hard to predict. . . There is much unpredictability in the actions of courts, litigants and defendants... There is little activity in transacting investments and hence little relevant data for benchmarking.” 

Obviously, Burford’s internal valuations are checked by its auditor, the London office of Ernst & Young. For every case where there is a year-on-year change in fair value, the auditor says it tests and challenges management’s assumptions, does external research and compiles relevant secondary-market trading data, such as exists. For cases where there is no change in value, the auditor does much the same but for a sample of cases. That sounds fine. Yet, much like the ways that Burford comes up with fair value in the first place, it’s hard to know from the outside what that really means in practice.

The second, and connected, concern is that Burford’s accounting profits – swollen by paper fair-value gains – contrast sharply with the rate at which cash leaves the group. In 2015, while the group recorded operating profit of $77m, its operating cash flow was minus $9m. By 2018 compared with operating profit of $344m, the cash outflow was $198m. Cumulatively in the five years 2014-18, there was a $1.2bn divergence between accounting profits, which relied heavily on fair-value gains, and cash outflows, which removed the paper gains. 

True, all may yet come good at Burford, though the pace of its share-price decline – at 717p, it’s down 65 per cent from its all-time high in mid 2018 – suggests otherwise. Perhaps more important, Burford prompts the thought that fair-value adjustments – great in theory – actually cause more problems for investors than they solve. If so, that would be because, at worst, the effects of IFRS 9 and IFRS 13 turn company accounts from a precise record of past transactions into glorified speculation about the outcome of future events. 

Not just that, but such speculation would be strongly influenced by each company’s own bosses. Paradoxically, that would tend to have the opposite effect to what accounting-standards setters wanted when they shaped the fair-value rules. It may make equity investment less efficient because values, rather than being shaped by scores of (mostly) independent financial analysts, would, in effect, be handed down by one or two company insiders. What would be fair in that?