Over the past few months, institutional ”experts” and politicians have cited fair value accounting (SFAS 157) as the primary cause for the meltdown experienced by the financial markets (see for example, the CNBC segment on September 30, 2008). Regardless of the validity of these statements, one clear implication of this debate was the increased political pressure experienced by regulatory bodies such as the FASB and the SEC to take some action. As a result, FASB had no choice but to make changes to the standard:

  1. Allowing managers and firms more discretion when valuing their financial securities, and
  2. Changing the definition of other than temporary impairment. For example, by allowing firms to distinguish between different determinates of revaluations, separating changes in expected cash flow from changes in expected risk premiums (discount rates), where only the former counts towards any other than temporary impairment experienced by financial assets.The unfolding of these events is a great empirical example of one of the frameworks described by Watts and Zimmerman in their paper, “The Demand for and Supply of Accounting Theories: the Market for Excuses” (TAR 1979). Specifically, the idea that accounting practices and theories are affected by government intervention and legislation, because they have evolved to accommodate the political process, which is centered on wealth transfers.

One example discussed by Watts and Zimmerman is the evolution of depreciation as an accounting standard, which was first lobbied for by the railroad companies in the nineteenth century. The introduction of depreciation lowered the profits reported by these firms and helped them argue for higher fares which were set by the government (and in some cases, specifically tied to profits). Additionally, reporting lower profits could reduce the pressures placed on politicians (by their constituents) to keep fares low. This of course created a wealth transfer from individual passengers to the owners of the railroad companies (given a constant level of service) and potentially to political affiliates as well. In response to this process a large body of academic work emerged which introduced various theories for and against expensing depreciation.

The case of the financial institutions is strikingly similar. After financial intuitions took on an excessive amount of risk by buying highly risky assets, while under the watch of various regulatory bodies, both the institutions and the politicians put pressure on the FASB and the SEC to change the accounting standards for these assets, so that the financial institutions could report higher earnings, and investor’s short-term concerns could be addressed. If the increased earnings result in increased share prices that are not accompanied by any economic change in the value of the assets, then this can be viewed as a wealth transfer from future shareholders to current shareholders as well, as future shareholders may see their equity value drop when the true value of the assets finally comes to light (ignoring any price protection that future shareholders may seek if they find this accounting practice troublesome). As a result, we should expect to see an increase in academic work discussing theories both for and against fair value accounting in financial institutions in the near future as well.

One item worth mentioning is that part of the argument raised by the financial institutions and the institutional “experts” favoring the regulatory change is that the revaluation of these assets is based on depressed prices in illiquid markets, which hurts the regulatory capital levels of these financial institutions, which then in turn affects their ability to lend and help restart the economy. However, this argument has several limitations that are discussed in detail in a paper entitled “The Crisis of Fair Value Accounting: Making Sense of the Recent Debate” (Laux and Leuz ). The two main issues raised are:

  1. Fair value accounting was never intended to rely on prices taken from illiquid markets and
  2. If there are regulatory issues related to how capital requirements are measured and met, it is not clear that changing the accounting standards, which are also designed to inform investors (and reduce levels of information asymmetry), is the desired solution.

Finally, let me close by saying that while the recent debate on accounting for financial securities has been very lively, the elephant in the room remains. Namely, what is the value of these institution’s loan portfolios, which are recorded at amortized costs? These assets make up a majority of most banks’ balance sheets, and the accounting for their value is much more opaque.