Improving fair value accounting

The turmoil on international financial markets is proving complex to a degree that few could have anticipated when it initially emerged in the summer of 2007. There is still much uncertainty over the duration and potential impact of this turmoil on the real economy. This episode has revealed a series of flaws in various areas of the international financial system. One issue on which regulators, supervisors and other interested parties are focusing is the application of fair value. In many cases discussions turn on quantitative and qualitative matters geared to improving valuation methods and their implementation, especially when applied to complex financial instruments. There is also in-depth refl ection about what information institutions should provide investors regarding the application of fair value, so that investors may take well-grounded decisions. Another area of the debate on fair value considers to what extent its application affects management and investment decisions, and particularly how it may exacerbate procyclical behaviour by financial markets. To examine the relationship between valuation and procyclicality and to identify some solutions to the perverse interaction of the two, the article discusses the advantages of fair value and its limitations, stressing in particular some of the most relevant ones which have emerged during the current financial turmoil. In addition, it puts forward some ideas that might contribute to improving fair value: the use of reserve valuations and of dynamic provisions. It is argued that they can not only improve fair value accounting but also lessen financial procyclicality.