In the most recent The Accounting Review (Vol. 87, No. 2), Caskey and Hughes examine how alternative fair value (FV) measures affect the ability of debt covenants to mitigate suboptimal investment decisions.  A primary result from the paper is that the FASB’s “highest and best use” measure of fair value is dominated by more conservative measures of fair value in debt contracting.  At first glance, I read the paper as suggesting that the “highest and best use” standard should be replaced with something else.  After a more careful reading, however, I don’t think this is what the authors are suggesting.  Nevertheless, this paper might have interesting implications for the FASB’s efforts in formulating a differential standard setting framework for private companies.

The issue in the paper is one of wealth transfers from creditors to shareholders/managers.  The study’s model employs control rights, which are frequently observed in debt covenants.  These rights give creditors control over whether to abandon or continue a project when the debt covenants are violated.  The main insight from the paper is that a conservative FV measure increases the likelihood that debt covenants will be violated, giving creditors the authority to abandon projects that produce a negative NPV.  The conservative FV measure they employ in their analysis is the lower of abandonment value or continuation value.  This is different from the FASB’s “highest and best use” concept, which is essentially the higher of those values.  The intuition is that the conservative FV measure enhances contracting efficiency between managers and creditors (relative to the FASB’s highest and best use) even though their conservative FV measure introduces a distortion in firm value.  The authors also recognize that creditors might inefficiently abandon too many projects – even some projects that are positive NPV.  So, they further analyze the offsetting effects of shareholders accepting negative NPV projects versus creditors abandoning positive NPV projects.  The authors conclude that contracting costs are minimized by using conservative FV measures.

It’s important to consider that Gigler et al. (2009 Journal of Accounting Research) find essentially the opposite results from this study; that is, Gigler et al. find that conservatism actually decreases debt covenant efficiency.  The reason for the difference is simply that Gigler et al. place more weight on an outcome where positive NPV projects are abandoned because the financial reporting numbers were too conservative.  Conservatism is more valuable in Caskey and Hughes because they assume that the costs of excessive abandonment fall disproportionately on inferior projects.  I can’t adequately assess which set of assumptions is more appropriate, but my intuition favors Caskey and Hughes.

More importantly, Caskey and Hughes assume perfect information for all shareholders and creditors.  Assuming away uncertainty, in my opinion, precludes the authors from implying that the FASB’s “highest and best use” measure is suboptimal for financial reporting purposes.  At the very least, this will be the case for firms where information asymmetry between managers and shareholders is high.  Using undistorted numbers to assess firm value is critically important to investors, and reducing agency costs will likely be more important to investors in these settings than reducing inefficient contracting costs.

However, I believe this paper has policy implications for firms where the source of capital is primarily debt and information asymmetry between capital providers and managers is relatively low.  Most private companies would probably meet these two criteria.