Financial services companies should not stop accounting for assets at fair value in illiquid markets, but better disclosure is required as to the rationale, assumptions and sensitivities behind these valuations, argues Fitch Ratings in a special report published today.

The rating agency notes that its report comes at a time when volatile and unstable conditions in the financial markets have caused many reporting financial institutions to call for a relaxation of fair value accounting, allowing issuers the option of when to apply fair value measurement and when to apply historical cost. However, Fitch argues that, “the fundamental distortions such unfettered flexibility would permit would not engender greater investor confidence in financial reporting nor would it foster sound capital markets or sound financial institutions.”

In its report, Fitch notes that fair values are helpful to analysts and investors when they represent realistic and reliable indications of the net present values of future cash flows. “The disconnect with market prices comes when there is no intention to sell an asset in the short term and a lack of market liquidity means that current values are either much higher or much lower than the amount that will ultimately be received for the asset,” it says. “However, holding assets in trading books is a clear indication of a company’s intent to sell in the short term and market values should be taken.”

More extensive disclosure will help investors to understand the limitations around the values reported, Fitch maintains. It stresses that these should include indications of market prices versus expected cash flows, amounts companies expect to lose in real cash on assets written down to market values and how such assets will be funded whilst they are held for longer than originally anticipated.

Fitch adds that it does not think that market prices not directly related to the assets being valued using internal models should be required as inputs, the agency also does not think that they should be ignored. “A company that is not using the best observable data available should explain why it is not using this, demonstrate why the alternative measurement is more appropriate and provide an indication of how the value would have differed if the market prices were used as inputs in the notes to the accounts,” it says.

“The most salient issue is not whether fair value per se should be used to report numbers, but how that fair value should be measured,” says Bridget Gandy, managing director in Fitch’s Credit Policy Group. “If values are being taken from markets that are not striking a fair balance between buyers and sellers, it is hard to argue that those values are fair.”