Two items in today’s news point to fair value accounting and why it’s returning to the spotlight.

The first item is the on-going investigation of what is behind the Freddie Mac earnings restatements. The second is a report on efforts by an insurance group led by AIG to derail IASB efforts at fair value accounting. Both items are part of developing stories that will soon impact corporates outside of the mortgage finance and insurance space.

FAS 133 flaws

As the Wall Street Journal is reporting, the Freddie Mac restatements will be in the billions, stemming from improper hedge accounting under FAS 133. There was always a greater likelihood that one of the mortgage finance giants would emerge as the FAS 133 Wall Street Journal headline, since the task of hedging the risks in mortgage finance, involving multiple interest, credit and optionality risks is a tough one, and Fannie and Freddie knew it would be tough to account for this.

At first, media reports painted as positive the fact that the Freddie Mac restatements were positive and not negative. In other words, the gains on the hedges that were deemed non-hedges for accounting purposes were no longer being deferred. This ignored the “hedging” notion that these gains were offsetting anticipated losses in the underlying (e.g. the mortgage paper), which presumably are still anticipated. The disconnect of hedge from hedged item in the accounting guidance was always the fundamental flaw in hedge accounting that FAS 133 inadequately addressed, preferring to focus on derivatives. This is also why it is difficult to glean the impact bringing forward the hedge gains will have on Freddie Mac’s future earnings.

Broader IASs

Just as Freddie Mac exposes flaws in a limited fair value approach, the insurance industry is aggressively seeking to counter acceleration of fair value accounting more broadly. According to the Wall Street Journal, an insurance group, led by AIG, is actively opposing international accounting standards (IAS 32/39) and the related IASB effort to push the fair value concept further into insurance accounting. These IASB efforts go further than FAS 133 and related FASB efforts to introduce fair value to a wider scope of accounting: financial instruments as opposed to just derivatives. Though the IASB has taken the lead on the fair value drive, FASB is set to follow, which is why the IASB trends should be followed closely by all concerned with US GAAP.

Fair value accounting has its flaws, not least of which is the AIG argument that it introduces meaningless volatility to earnings statements. However, insurance firms, aside from broker-dealer banking operators, have as good a shot as any at making fair value accounting work as a means of giving investors and the markets a more telling portrait of financial position.

Just as Freddie Mac has revealed how FAS 133 does not go far enough--it’s focus on derivatives has left financial statement readers in the dark on hedged items--the insurance firm complaints show how broadening the focus to financial assets and liabilities is not going to offer an easy solution. But, if accounting is going to move increasingly toward a fair value model, as its standard setters plan, they must use the IASB’s insurance market “test” to prove the model’s practical efficacy. The Exposure Draft of Phase I of this IASB project is due out in Q3, with a tight implementation timetable to become effective for EU adoption of IASB standards in 2005.

If fair value accounting cannot be made to work with insurance firms, it cannot be made to work with non-financial corporations, and the current course to fair value accounting should be reversed. Further, by establishing guidelines for accounting for insurance risk management activities, the IASB effort will help define accounting for all risk management activities.  For example, at its meeting earlier this week, the IASB discussed the definition of insurance risk “as risk other than financial risk” (defined by IAS 39), along with other pre-ballot items to become part of the exposure draft.

This is a high stakes experiment that all should watch closely for its broader impact, not to mention its transforming effects on an insurance market already in the midst of a paradigm shift.