While I generally think highly of the The Economist, this article contains one of my pet peeves, which is a loose discussion of fair value. In particular, the article states that “In 2009, under its previous chairman, Bob Herz, FASB narrowly voted 3-2 that all assets should be booked at fair value on banks’ balance-sheets” (emphasis added).

Actually, this vote was part of the boards’ financial instruments project and so would not affect the accounting for any nonfinancial asset. Some might say, well, most bank assets are financial assets. That’s fair, but banks also hold nontrivial amounts of nonfinancial assets (e.g., Bank of America had over $100 billion of PPE, goodwill, and other intangible assets at the end of 2010).

The bigger point is that a casual reader might mistakenly infer from this quote that the FASB was on a mission to extend fair value accounting to all assets for all companies. That is certainly not the impression I have ever gotten when listening to the boards deliberate on their various projects. And the inclusion of one word could help avoid misunderstanding.

Oh well, I’ll forgive The Economist this time…

The answer to the latter is a clear “yes” because the new guidance requires substantially more disclosures for level 3 than for level 2.  This led to some very interesting discussion, which unfortunately was not archived.  In particularly, if you look at the first slide deck that Phil posted, slides 6 and 7 discuss the additional disclosures.  The reporting entity will group assets into categories, and for each category, the company must disclose the type of valuation technique used and the unobservable inputs.  Ben mentioned a few of FVM approaches currently used by companies:

non-binding brokers quotes:  The reporting entity gets an estimated price from a broker.  Since the broker is not offering to buy at the quoted price (hence the term “non-binding”), the broker might spend very little time preparing the FVM.  Another problem is that the reporting entity must ascertain details underlying the broker’s methodology in order to comply with the new disclosure requirements, but brokers are hesitant to provide information about their proprietary pricing models.

in house valuation experts:  For some reporting entities, executing the company’s business model requires frequent FVM’s.  These companies may hire valuation experts for other reasons, and as a result, will generate its own FVM for financial reporting.

binding broker quotes:  The broker promises to buy the asset for the quoted price (quote expires after a few days).  This almost sounds like level 1 FVM to me.

Some other FVM approaches were mentioned briefly, but I do not recall what they were.

Academic accounting researchers have shown great interest in companies’ accounting choices.  At first, the new FVM guidance that Ben discussed appears to mandate accounting policy, which makes it a poor venue for studying accounting choice.  But what seems unique is that firms can choose how to comply with the mandate (measure FVM using non-binding broker quotes, in house estimates, binding broker quotes, or multiple methods), and the firms are asked to make fairly transparent disclosures about these choices.

I asked Ben what factors are expected to drive the choice of FVM method.  One factor is whether in house valuation expertise is available, because if this expertise does not already exist, he doubted entities would develop it just for complying with the new guidance.  Second, he expected market pressure over time might influence the choice; the hypothesis (although he did not label it this way) went as follows – companies initially disclose a methodology that is pretty weak and subject to significant errors (e.g., non-binding broker quotes or FVM’s prepared by in house experts using questionable inputs), the market applies a larger cost of capital to those companies, the companies improve their FVM methods and disclosures, and the cost of capital falls.

Obviously an archival test of this hypothesis will have to wait until we have a long enough time-series of disclosures.  But I expect some academics will be looking closely at the new disclosures, either as preparation for future research or for interesting class discussions about accounting disclosure choices.

• First click on “Read more” below and then click here for the first slide deck.
• First click on “Read more” below and then click here for the second slide deck.

Unfortunate technological difficulties prevented us from recording the session.

The FASRI Round Table series continues at 4pm Eastern time on Wednesday, May 25th. Jeff Hales and Phil Shane will host the program, and our guest speaker is Ben Couch, who will talk about the new Accounting Standards Update (ASU No. 2011-04) on Fair Value Measurement (codification topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs.

Ben Couch is a valuation expert at E&Y and is currently a project manager at the FASB in the middle of a 2-year practice fellowship. Undoubtedly, the entire academic financial reporting community would do well to have a primer in how audit firms evaluate the efficacy of level 2 and level 3 valuations in accordance with the new rules which update FAS 157.  This round table provides that primer and offers the opportunity for questions about issues relevant to your teaching and research programs. The session will include a 15-20 minute presentation by Ben, and 40-45 minutes of questions and insights from all round table participants. Please click here for the most recent information about the FASB’s fair value measurement project, and click here for the recently published ASU.

We hope you can join us for this discussion, as we’re sure you will find interesting applications to your teaching and research programs.  Please put this event on your calendar!

Participation:

FASRI Round Tables now are conducted using WebEx. To participate, either:

Follow the simple instructions at the registration site:

https://faf.webex.com/faf/j.php?ED=151006607&RG=1&UID=1066609172&RT=MiMxMQ%3D%3D

OR

send me an email at pbshane@fasb.org and I will return an email with a clickable link to the meeting registration site.

OR

go to http://webex.com anytime on May 25th.  Then: click on “attend a meeting”; enter the meeting number 483309515; fill in your name, email address and the meeting password, Fasri001 (case sensitive); click on “join”; and decide whether you want to use your computer or a telephone for audio and speaking.

If you choose to use a telephone, click on “Enter a phone number” and enter your phone number.  You will get a phone call.  Press one on your phone keypad when prompted. Now you should be in the meeting and can use your phone to hear and speak.

If you choose to use your computer, click on “use computer for audio” and then click on “call using computer”.  Now you should be in the meeting and can use your speakers and microphone to participate.

If you receive an error message or need help at any time, contact me at 203-956-5317.

See you there!

Our next FASRI roundtable is scheduled for 4pm-5pm ET Wednesday, November 17th.  Richard Frankel (Washington University) will be joining us to talk about his recent paper, Panacea, Pandora’s Box, or Placebo: Feedback in Bank Mortgage-based Security Holdings and Fair Value Accounting.  The paper continues several themes that FASRI roundtable participants have seen before.  Like Bertomeu and Magee’s paper in the last roundtable, the paper is from the most recent JAE conference, and also like that paper, this one addresses a process by which the choice of accounting methods can have real impacts on future value creation.

In Bertomeu and Magee, shocks to asset values create pressures to change accounting standards, which in turn affects value creation.  The present paper is based on work that Haresh Sapra discussed at a roundtable in Spring of 2009.   We don’t have an audio archive from Haresh’s session, but this will give you a sense of Haresh’s arguement.

Pedestrians on the bridge react to how the bridge is moving. When the bridge moves from under your feet, it is a natural reaction to adjust your stance to regain balance. But here is the catch. When the bridge moves, everyone adjusts his or her stance at the same time. This synchronized movement pushes the bridge that the people are standing on, and makes the bridge move even more. This, in turn, makes the people adjust their stance more drastically, and so on.

In other words, the wobble of the bridge feeds on itself. When the bridge wobbles, everyone adjusts his or her stance, which makes the wobble even worse. So, the wobble will continue and get stronger even though the initial shock (say, a small gust of wind) has long passed.

What does all this have to do with accounting standards and financial markets? Financial markets are the supreme example of an environment where individuals react to what’s happening around them, and where individuals’ actions affect the outcomes themselves. The pedestrians on the Millennium Bridge are rather like modern banks that react to price changes, and the movements in the bridge itself are rather like price changes in the market. So, under the right conditions, price changes will elicit reactions from the banks, which move prices, which elicit further reactions, and so on.

Rich will be discussing evidence that supports such feedback effects.  From the first and last paragraphs of his paper’s introduction:

We study how changes in commercial bank mortgage-backed-securities (hereafter MBS) holdings relate to changes in MBS prices and mark-to-market accounting during the Financial Crises of 2007. Our purpose is to understand how security holdings influence the role of commercial banks in providing liquidity during the crises. Theory suggests banks’ security holdings add systemic risk to the economy, because banks can be forced to sell securities when prices fall (Shleifer and Vishny, 2009, Allen and Carletti, 2008, Brunnermeier and Pedersen, 2009) and that mark-to-market accounting can accentuate this “feedback” effect (Plantin, Sapra, and Shin, 2008, Allen and Carletti, 2008). In these models, liquidity constraints cause prices to deviate from discounted-cash-flow values and precipitate sales. Therefore, we examine bank holdings in the face of declining prices to understand whether banks increased holdings of securities (as would be expected of liquidity providers) or whether they sold securities suggesting banks were overwhelmed by the financial avalanche.

Overall, our study provides evidence that banks are more likely to sell MBS when liquidity declines. Furthermore, we provide evidence consistent with the easing of mark-to-market accounting rules limiting banks’ feedback trading and thus enhancing shareholder wealth. This study lends credibility to the belief that financial reporting rules have real effects. The pressure placed on the FASB to alter the valuation of distressed assets and change the accounting treatment of unrealized losses is indicative of these effects. Our tests suggest a specific consequence for a bank’s trading activities.

Join us for what promises to be a very interesting discussion.

You can join us on the web (Windows only, no Macs) or phone in.  Details on how to participate are here.

UPDATE:  SLIDES FOR THE PRESENTATION ARE HERE.

UPDATE:  GRAPH FOR FEDERAL RESERVE BALANCE SHEET HERE.

UPDATE:  AUDIO FOR THE SESSION IS HERE.

I was very surprised to read GMU economist Tyler Cowen claim that “The Fed has resisted being audited“, and related posts by other GMU-affiliated faculty debating the issue. (See here, for example).

A little searching suggests that economists and accountants don’t speak the same language or attend to the same issues.  In fact, the Fed does provide audited financial statements, which you can find here.  The dispute really seems to be about whether the GAO should be examining and reporting on the Fed’s policy and operational decisions and processes, as indicated in Bernanke’s letter in May.  That may or may not be a good idea, but it isn’t really what comes to my mind when I hear the words “Audit the Fed.”

However, the searching was still worthwhile, as I came across a very interesting paragraph regarding the Fed’s financial statements.  It turns out, the Fed doesn’t use GAAP, but instead uses accounting specific to Federal Reserve Banks.  As they explain (all emphasis mine):

The primary difference between the accounting principles and practices in the Financial Accounting Manual and GAAP is the presentation of all System Open Market Account (SOMA) securities holdings at amortized cost rather than the fair value presentation required by GAAP. Treasury securities, government-sponsored enterprise (GSE) debt securities, Federal agency and GSE mortgage-backed securities, and investments denominated in foreign currencies comprising the SOMA are recorded at cost on a settlement-date basis rather than the trade-date basis required by GAAP. The cost basis of Treasury securities, GSE debt securities, and foreign government debt instruments is adjusted for amortization of premiums or accretion of discounts on a straight-line basis. Amortized cost more appropriately reflects the Reserve Banks’ securities holdings given the System’s unique responsibility to conduct monetary policy. Accounting for these securities on a settlement-date basis more appropriately reflects the timing of the transaction’s effect on the quantity of reserves in the banking system. Although the application of fair value measurements to the securities holdings may result in values substantially above or below their carrying values, these unrealized changes in value have no direct effect on the quantity of reserves available to the banking system or on the prospects for future Reserve Bank earnings or capital. Both the domestic and foreign components of the SOMA portfolio may involve transactions that result in gains or losses when holdings are sold prior to maturity. Decisions regarding securities and foreign currency transactions, including their purchase and sale, are motivated by monetary policy objectives rather than profit. Accordingly, fair values, earnings, and gains or losses resulting from the sale of such securities and currencies are incidental to the open market operations and do not motivate decisions related to policy or open market activities.

I haven’t yet done enough searching to determine whether the fair values are disclosed, even if they aren’t recognized, and what the quality of that disclosure is.  But it is worth pointing out that audits and disclosure are not always wonderful things.  Disclosure can reduce welfare by exposing everyone to the risk of price changes (when the bad news comes out), as discussed in Dye’s 2001 JAE discussion paper.  In the case of systemic risk, disclosure of bad news could trigger a bank run, making society better off with worse disclosure.  I am not saying the Fed shouldn’t disclosure its financial position (including fair values)…just that the questions at the start of this post don’t have answers as obvious as you might have thought.

Since then I’ve been pointed to a rebuttal article I enjoyed reading (these fair value arguments can be so much fun).

To prove his point (and ours, unwittingly), he made this prodigious gaffe: “For example, accounting rules allowed the creation of off-balance-sheet special-purpose vehicles that resulted in increased leverage and risks in the financial system. Now that we are in the middle of a crisis, FASB is proposing to put those vehicles back on the books of banks, which will reduce their capital ratios and their ability to lend. These and other accounting rules are far too important to be left to accountants without proper government oversight.”

Here are his mistakes: It wasn’t rules that created excessive leverage, but the bankers’ folly when they voluntarily drove truckloads of money through the loophole; his wish to leave this loophole open would produce glaringly false representations; and all good accounting will do is reveal how far bankers reduced their real capital ratios with excessive leverage.

In other words, bankers found a loophole and exploited it. When the problem exploded on itself, bankers blamed the FASB for creating the problem but insisted that they leave the loophole open . . . shame on you for letting us make bad decisions, double shame for not letting us keep making them.

He might as well blame thermometers for hot weather or X-ray machines for broken bones. Here are the facts: Bankers took extreme risks without realizing it; when the markets finally assessed the risk, they pummeled the instruments’ values; and GAAP required these facts to be reported. Rather than cope with clear reality, Isaac tried to drag others into his absurd world of denial.

I don’t know if there is much research potential in either article, but there is sure potential for classroom fun! A room full of MBA’s could debate this for hours and learn some valuable lessons about fair value, special interests, and standard setting.

I don’t think he really likes the idea. I encourage you to read the article, but here are some quotes that I found particularly poignant.

“FASB’s proposal is incomprehensible and irresponsible”

“The three members of the board who voted in favor of this proposal are like religious zealots worshipping at the altar of fair value. Not only is this proposal bad for the economy, it is bad accounting because it doesn’t recognize the banking business model.”

“Banks are going to stop making loans and simply hold short-term investment securities. That is what they did in the Great Depression, which led President Roosevelt in 1938 to order the bank regulators to stop using market-value accounting and instead use historical cost accounting. FASB board members have no clue about the economic destruction they are causing.”

I found the last point informative. I wonder if anyone has written a paper on the history of fair value accounting. I also wonder how other banking regulators view the proposal.

The basic argument tying fair value accounting to amplified procyclicality is that auditors required banks to write down affected assets to unrealistically low values as reflected by ABX index prices. Because the Financial Crisis caused a drop in liquidity, ABX index prices allegedly reflected distressed prices rather than prices from an orderly market. Bank managers contended that ABX prices, being artificially low relative to the bank managers’ perceived asset values, caused unnecessarily large impairment charges. That is, impairment charges would have been lower had bank managers been permitted to use their personal assessments of value, and the economy would have suffered a less severe downturn.

Although, in principle, an “excessive” fair value-related impairment charge could have amplified procyclicality of bank asset prices, we believe this is unlikely for two reasons. First, this claim can only apply to those bank assets that were either measured at fair value or for which fair values apply when determining impairment. The proportion of bank assets for which this is the case is limited. Laux and Leuz (2010) reports that during the 2004 to 2006 period banks held approximately of 50% of their assets in loans and leases, which are not subject to fair value accounting and are not impaired to fair value. Although, for the 14 largest US commercial banks, Shaffer (2010) reports the decline in Tier 1 capital during the Financial Crisis arising from impairments of loans averaged 15.6%, those impairments were based on an incurred loss model and not on fair value. Therefore, as discussed in section 6, although impairments of loans, i.e., loan loss provisioning, during the Financial Crisis likely had procyclical effects, fair value accounting played no role relating to loans.

In other words, there was a downward spiral in loan values, but fair value accounting played no role in it because loan values are not calculated using fair value. They are calculated using the incurred loss model.

The authors go on to explain that fair value accounting may have played some small role in the devaluation of other assets, however, bank regulators apply a prudential filter to neutralize some fair value gains and losses when calculating Tier 1 capital requirements. In fact, “Prudential filters neutralized the effect on Tier 1 capital of some fair value losses and the larger effect on Tier 1 capital arose from loan losses that were not determined using fair value.”

The authors also discuss the role that asset securitization, derivatives, and loan loss provisioning played in the financial crisis. The paper is forthcoming in the European Accounting Review.

If you’d like more information on this Round Table and Eddie’s research, click here to see the post introducing the topic.

“June 30, 2011, is an arbitrary deadline and it’s not one that’s been put in place by the SEC or by our road map,” said Kroeker. Citing FIN 46(R) as an example of an accelerated project that later needed to be reworked, Kroeker said that what’s most important is to ensure through the exposure process that the final standards are a “long term, sustainable solution.”

I suspect the FASB is not all that surprised by Kroeker’s view, given how good the lines of communication typically are between the FASB and the SEC. However, I suspect the IASB and other supporters of a single, global accounting standard will be a little surprised and will interpret Kroeker’s comments as (further) evidence that the US will not be adopting IFRS any time in the near future. They may even increase the volume on their arguments that the IASB should not give so much preferential treatment to the FASB and SEC in its standard setting activities. Should make for some interesting articles over the next few weeks!