In the U.S. the SEC was established in 1934 as a result of some significant chicanery involving financial frauds and accounting trickery during the roaring twenties.  When Congress passed the securities acts, it desired that investors obtain information, usually financial in nature, on the securities being traded in the primary or secondary markets.  It also prohibited deceit, misrepresentation, and other frauds surrounding the sale of securities.

The SEC in 1939 promoted accounting standards-setting by the AICPA, which the AICPA implemented via its Committee on Accounting Procedure.  The purpose of this committee was to assist the SEC by creating accounting standards that provided appropriate information to investors and prospective investors and, to the extent possible by rules, to avoid deceit and misrepresentations.  Successors to the Committee on Accounting Procedure—the Accounting Principles Board and today’s FASB—were tasked with the same objectives.

So what was so revealing about the recent comments by Jacques de Laroisiere?  It turns out that this maxim was employed as a principle by which he attacked fair value accounting.  He cannot tell the truth—that fair value accounting is not good for managers, especially managers of banks and insurance companies—so he hides behind a more palatable dictum.

Dow Jones reports that Mr. de Laroisiere claimed that “fair value accounting rules make sense for investment banks and trading houses but are ‘irrelevant’ for long-term shareholders such as pension funds.”  Tellingly, he provides no proof for this remark, but merely asserts its validity.

I believe that pension funds and other long-term investors would benefit from fair value measurements for two fundamental reasons.  First, these measurements reveal the changes in the economic wealth of the company.  As the firm enjoys greater future cash flows and lower interest rates, the shareholders prosper. 

When fortunes reverse and the corporation suffers less future cash flows and higher interest rates, the firm and the shareholders have declines in their wealth.  Audited fair value accounting measurements approximate these changes, but amortized historical cost does not.  Thus, fair value numbers are more informative than historical cost and thus more in harmony with the mandate issued by the Congress when it passed the securities acts of 1933 and 1934.

Second, historical cost masks the real variations in wealth, while fair value measurements disclose the variability in income.  Despite all the consternations by banking associates, the red ink brought out by fair value numbers have accurately revealed the extent of the financial crisis to shareholders.  The vicissitudes of the financial crisis were caused mainly by reckless and risky decisions by bank managers and partially by institutional defects in the banking structure.  Fair value accounting did not cause these problems; instead, it revealed the financial consequences from the stupid moves by these managers and directors.

Dow Jones also reports that Mr. de Laroisiere said that the variability of fair value numbers could “risk reducing demand for equity” of insurers because of their impact on capital adequacy regulations.  Apparently he is afraid that “sharp balance-sheet adjustments” could drive prices down.  That may or may not happen, depending on the efficiency of stock markets.

If stock market agents are rational and price securities with an estimate of the economic earnings instead of estimating earnings variance with historical cost numbers, then fair value accounting will not have the effect on stock prices posited by de Laroisiere.  Even so, disclosures of fair values are useful because they should reduce the information costs of investors.  If the market is not efficient with respect to these issues, then the stock may be currently mispriced, and the fair values will prove quite informative and help drive prices to their proper levels.

While Jacques de Laroisiere’s initial comment that rules should not hurt investors serves as a good foundation for corporate reporting, we learn that he really wants accounting rules not to hurt the managers and directors of banks and insurers.  As they have greatly injured investors and creditors and taxpayers with their irresponsible decisions during the past few years, we should oppose such logic.  Let’s support fair value accounting and the light that it can shed on management’s real performance.