Fair Value or Fairy Value

A lot of readers of Diamond Finance have been watching closely the meltdown o the financial markets.  When I saw an article in The Economist’s 21^st July issue titled “Bearing It All” which dealt with the fair value of derivatives, the implications for diamond accounting started to become apparent.  The article dealt with the difficulty in ascertaining the fair value of securities backed by sub-prime mortgages in light of the crisis in that market.

The debates in the accounting profession regarding IFRS 39, accounting for financial derivatives have been left to the banking and financial services industries.  I even skipped out that part of the IFRS course I recently took, expecting the act of omission to boomerang back, which it now has.

The closest the sightholders came to grappling with the concept of fair value was during the DTC’s prevarications over whether or not to require IFRS for all sightholders in the winter of 2005/6.  The main assets which would have required revaluation were the land, building, plant and equipment.  Buildings and some manufacturing equipment are normally depreciated in accordance with the rates imposed by the local tax authorities, and as a result can be recorded in the balance sheet at values well below their fair values.  For example, a factory building in some jurisdictions is depreciated over 20 years, but in today’s heated property markets, today’s 20 year old factory can be worth a multiple of its original cost.  The catch being that in some jurisdictions, a revaluation of fixed assets can give rise to a tax charge.  This, however, is covered by IFRS 16 and not by IFRS 39.

The article described two hedge funds of Bear Stearns which had invested in securities backed by sub-prime mortgages.  These are mortgages lent to higher risk borrowers in the US for a higher rate of interest and which are ‘packaged together’ and sold as collateral for other financial transactions.  The problem was that when the mortgagees started to default on their payments nobody else wanted to buy these higher risk packages so their price went down.  It is politely called an ‘illiquid market’ when the real term is low value or valueless assets.

Before IFRS 39, financial derivatives were recorded at historic cost, under IFRS 39 they have to be recorded at their fair value, i.e. the price it would fetch on the market.  But many complex derivatives do not trade smoothly and frequently in “arm’s length markets.”  Instead, the accountants have to use computer models which simulate trading to reach a valuation, but are easy to tweak to reach the desired valuation.  And, if the fund managers sell some derivatives at a loss in order to raise cash, they risk pushing down the market and devaluing their whole portfolio of that class of derivative.  Instead, the managers are tempted to hold the derivatives at cost even when they know they are practically worthless.

One consultancy, RiskData, estimated that one third of the 1,000 hedge funds it studied were “smoothing” the results of illiquid securities to avoid volatility in their accounts.  Using historic cost is also problematic as it too involves the use of guesses such as for depreciation rates, and in some transactions, the historic cost, other than brokerage and professional fees, can be zero.

The accountants and auditors, who are usually blamed for unreliable financial statements, have to resort to making educated assumptions and disclosing them in the notes.

With all of the noise concerning commoditisation of diamonds over the last few months, the CFOs and auditors on 31^st December each year will have to be able to value the futures and options that are the direct result of commoditisation.  Fortunately, diamonds always have an intrinsic value, which cannot necessarily be said for sub-prime mortgage backed securities. 

It is expected that most of the annual polished output of $18bn to $20bn will continue to be sold directly down the pipeline, which will mean a relatively ‘illiquid’ market for the futures and options – illiquid here genuinely means low trading volumes.   The ramification is that it will be difficult or even impossible to value portfolios of diamond backed derivatives at the end of the year which may deter the fund mangers whose funds we want to attract into the industry.  It will certainly cause a headache for those same bankers pushing for commoditisation, who will now have to value these derivatives for Basel 2.

The good news is, more work for the accountants who understand what’s going on.

socrates@diamondfinance.info