Fair Value Accounting From the Mouths of Babes Students: Zoe-Vonna Palmrose’s 2005 AAA Address
A few weeks ago, in a post entitled “Why Do Standard Setters Make Such Awful Decisions?,” I cited Zoe-Vonna Palmrose as one of several academics who think that the FASB’s embrace of fair-value accounting is so obviously mistaken that even children could see it. Bill Kinney pointed out that my recollection of Zoe-Vonna’s 2005 presentation to the AAA was not quite right: Zoe-Vonna’s point was that the FASB is so obviously mistaken that even accounting students could see it.
To set the record straight, Zoe-Vonna has generously provided her prepared remarks from the talk in question: A panel discussion entitled “The FASB’s Move Toward Fair Value in Accounting: Is it Auditable?” You can download her complete prepared remarks here. The panel was moderated by Bill Kinney, and also featured Ross Watts and Katherine Schipper. Zoe-Vonna opened her talk with this:
I would like to begin by asking you to consider two questions. The initial question is one you might pose to your students at the start of their first accounting course. The question is as follows. Suppose you had the choice of preparing or using financial statements based on: (1) actual transactions, (2) expected transactions, or (3) hypothetical transactions. Which seems to make the most sense to you? Which makes the least sense? Which would you choose?
For the second question, instead of an accounting class, suppose you are teaching an introductory auditing class. You have explained that auditors provide assurances that GAAP financial statements are free of misstatement. Of course, your students also know that auditors can get sued, disciplined, penalized, and otherwise punished if the financial statements are alleged to be misstated. So, what do you think? If auditors could choose, would it be to audit: (1) actual transactions, (2) expected transactions, or (3) hypothetical transactions?
Zoe-Vonna then walks through a hypothetical class discussion illuminating the dangers of relying on hypothetical transactions.
While my specific recollection of the talk was flawed — criticism of FASB flowed from the mouths of students, not babes — Zoe-Vonna is clearly arguing that FASB’s embrace of Fair Value is so mistaken that it is obvious even to students. As she says, “I suspect both groups of students would be dumbfounded when you tell them that their intuition and common sense do not apply here, because the standard setters are embracing hypotheticals in their push for fair value financial reporting” [emphasis mine].
So I repeat my question from the prior post, which I ask in all sincerity: Why do standard setters make such awful decisions? They don’t seem to be bending to political pressures, which tend to push them away from fair value. A misguided ivory tower view? That would cast academics as the bastion of practicality. Or it is just mistaken or misapplied theory?
While I take issue with the “sound bite” that Rob used to lead this thread (standards setters do not always make awful decisions), I will offer one tidbit of why fair value accounting might be attractive to a standard setter. Note that this is one small piece of the puzzle, as I believe many other factors are at play.
What have the SEC, academics, investors and others been telling the standard setters over the past 20 plus years? Investors want timely decision useful information. The SEC and academics loathe income manipulation. Everyone seems to like the idea of financial statements that can be compared across entities. If for the moment we assume fair value measurement techniques are reasonably accurate and unbiased, I submit that fair value accounting will address most of these concerns better than any other single approach for non-operating assets.
Consider the “cherry picking” or “gains trading” and lack of comparability that occurs when readily marketable securities are reported at historical cost. Zoe-Vonna could have asked her auditing students “Is it easier to track the historical prices in the twenty different past transactions in which the client bought IBM stock, or is it easier to look up the price of IBM in today’s Wall Street Journal?” I think that for this class of transactions, her students could easily prepare and audit financials that used fair value.
Problems arise when the fair value model is extended to (a) less marketable items or (b) selected parts of a company’s operating activities. When academics consider (a), they immediately expect management to supply biased fair measures for assets or liabilities that do not trade in a liquid market. When FASB staff members consider (a), they consult with people having practical measurement experience, but they probably get varied and self-interested responses. At an intuitive level, if companies participate in a market for specific types of assets and liabilities, then prices exist, with the only remaining question being how to objectively capture the prices for accounting purposes. Thus, I think a big part of the difference between views expressed by folks like Zoe-Vonna and the standard setting staff arise due to differences in the perceived difficulty and bias in making fair value measurements, as well as the staff’s perception that the non-fair value approaches often fail to meet one or more of their constituents’ objectives for financial reporting.
For what it’s worth, I would ask whether an auditor can audit a lower of cost or market measurement? Those measurements existed three decades ago when I was an undergraduate student. Seems like all such measures involve a hypothetical transaction (at what price could the company sell its inventory today). If lower of cost or market value is measurable and auditable, then why is it so hard to assess market value alone?
To answer your question.
One reason why standard setters argue for fair value (but not the only one) is that many (but certainly not all) analysts and especially the CFA Institute which professes to speak for thousands of analysts worldwide, insists that Fair Value shold be the measurement approach. At a recent panel I hosted/chaired at the AAA meetings, with senior analysts in financial services , one argued there was not enough use of fair value i.e. everything should be on fair value (he used to analyze Freddie and Fannie amongst others)…another that fair value was a travesty and was destroying the banking system (she covered primarily commercial banks but also Fannie and Freddie in a previous position)…and a third, who had also been a Treasurer and CFO of investment banks before becoming an analyst, suggested a mixed model could make sense…..
Of course we see the same mix of views amongst academics… so there are many sides to the debate from both informed and uninformed participants.
Judging standard setters from afar is much easier than making the choices when they have well-meaning but often myopic consituents who are using their own conceptual framework as a base.
@Bob,I take issue with my ‘sound bite’ too, and let me emphasize that I don’t personally think standard setters make awful decisions, but many others do. My question to them is why.
@Trevor,I agree with your assessment of how much variation there is in user viewpoints. Maybe I am over-reading your comment, but you say that the CFA Institute “professes” to speak for analysts. Obviously, with such a diversity of views, it is hard for leadership to summarize the views of its membership. But I have heard a number of people suggest that there is a pretty big disparity between the views of analysts generally, and the views expressed in CFAI reports. Does your use of the word ‘professes’ indicate that you agree?
@Rob…I was on the committee for some time and found the majority of the members were technical accountants/consultants, not analysts who had to make recommendations and investments….they have worked hard to get more representation etc but it is tough to get broad participation in surveys and committees for reasons you would know well…As a useful anecdote I was talking about these FV issues in banks and insurance companies with Doron Nissim and about 40 buyside investors and analysts a short time ago…the vast majority (a biased sample given our host)were violently opposed to FV for these companies….but when pushed on it they did not have a good alternative….and that is the real dilemma, it is much easier to criticize an approach than to come up with an alternative that is superior (esp in any pareto context), especially if the objectives people start with are not uniform.
@Trevor, your anecdote echoes something Mary Barth said to me several years ago when I was asking her why the IASB was following the asset-liability approach and fair value. Her response was along the lines of “well, we’ve tried the other models, and they all break down as you continue to push them. This is the only one that hasn’t broken yet.”