What is Fair Value Accounting

Text-only Preview











FAIR VALUE ACCOUNTING:
UNDERSTANDING THE ISSUES
RAISED BY THE CREDIT CRUNCH



Prepared by

Stephen G. Ryan
Professor of Accounting and Peat Marwick Faculty Fellow
Stern School of Business, New York University

July 2008












FAIR VALUE ACCOUNTING: UNDERSTANDING
THE ISSUES RAISED BY THE CREDIT CRUNCH


prepared by

Stephen G. Ryan
Professor of Accounting and Peat Marwick Faculty Fellow
Stern School of Business, New York University


for the Council of Institutional Investors


July 2008

∗ This white paper was commissioned by the Council of Institutional Investors for the purpose of educating
its members, policy makers and the general public about the important and timely topic of fair value
accounting and its potential impact on investors. The views and opinions expressed in the paper are those
of Professor Ryan and do not necessarily represent the views or opinions of the Council members, board of
directors or staff. Official policy positions of the Council are determined only after an extensive due
process that includes approval by a vote of the Council board and membership.

FAIR VALUE ACCOUNTING: UNDERSTANDING
THE ISSUES RAISED BY THE CREDIT CRUNCH


Table of Contents

Executive Summary ............................................................................................................ 1
I. Introduction................................................................................................................. 2
II. Background Information Abstracting from the Credit Crunch................................... 3
A. Fair
Value
Accounting............................................................................................ 3
B. The Limited Alternative of Amortized Cost Accounting ....................................... 5
C. The Unsatisfying Mixed-Attribute Accounting Model for Financial Instruments . 7
III. FAS
157 .................................................................................................................. 9
A. Definition of Fair Value.......................................................................................... 9
B. Hierarchy of Fair Value Measurement Inputs ...................................................... 10
IV.
Potential Criticisms of Fair Value Accounting During the Credit Crunch........... 11
A. Unrealized Gains and Losses Reverse .................................................................. 11
1. Bubble
Prices .................................................................................................... 11
2.
Skewed Distributions of Future Cash Flows .................................................... 12
B. Market
Illiquidity .................................................................................................. 14
C. Adverse Feedback Effects and Systemic Risk...................................................... 15
V. Summary of Reasons Why Some Believe that Fair Value Accounting Benefits
Investors............................................................................................................................ 16
VI.
Summary of Reasons Why Some Believe that Fair Value Accounting Hurts
Investors............................................................................................................................ 18


FAIR VALUE ACCOUNTING: UNDERSTANDING
THE ISSUES RAISED BY THE CREDIT CRUNCH


Executive Summary

Fair value accounting is a financial reporting approach in which companies are
required or permitted to measure and report on an ongoing basis certain assets and
liabilities (generally financial instruments) at estimates of the prices they would receive if
they were to sell the assets or would pay if they were to be relieved of the liabilities.
Under fair value accounting, companies report losses when the fair values of their assets
decrease or liabilities increase. Those losses reduce companies’ reported equity and may
also reduce companies’ reported net income.

Although fair values have played a role in U.S. generally accepted accounting
principles (GAAP) for more than 50 years, accounting standards that require or permit
fair value accounting have increased considerably in number and significance in recent
years. In September 2006, the Financial Accounting Standards Board (FASB) issued an
important and controversial new standard, Statement of Financial Accounting Standards
No. 157, Fair Value Measurements (FAS 157), which provides significantly more
comprehensive guidance to assist companies in estimating fair values. The practical
applicability of this guidance has been tested by the extreme market conditions during the
ongoing credit crunch.

In response to the credit crunch, some parties (generally financial institutions)
have criticized fair value accounting, including FAS 157’s measurement guidance. Those
criticisms have included:

• Reported losses are misleading because they are temporary and will reverse as
markets return to normal
• Fair values are difficult to estimate and thus are unreliable
• Reported losses have adversely affected market prices yielding further losses and
increasing the overall risk of the financial system.

While those criticisms have some validity, they also are misplaced or overstated in
important respects.

The more relevant question is whether fair value accounting provides more useful
information to investors than alternative accounting approaches. The answer to that
question is “yes.”




Some of the key reasons why fair value accounting benefits investors include:

• It requires or permits companies to report amounts that are more accurate, timely,
and comparable than the amounts that would be reported under existing
alternative accounting approaches, even during extreme market conditions
• It requires or permits companies to report amounts that are updated on a regular
and ongoing basis
• It limits companies’ ability to manipulate their net income because gains and
losses on assets and liabilities are reported in the period they occur, not when they
are realized as the result of a transaction
• Gains and losses resulting from changes in fair value estimates indicate economic
events that companies and investors may find worthy of additional disclosures.

I. Introduction

During the ongoing credit crunch,1 the markets for subprime and some other asset
and liability positions have been severely illiquid and disorderly in other respects. This
has led various (possibly self-interested) parties to raise three main potential criticisms of
fair value accounting. First, unrealized losses recognized under fair value accounting may
reverse over time. Second, market illiquidity may render fair values difficult to measure
and thus unreliable. Third, firms reporting unrealized losses under fair value accounting
may yield adverse feedback effects that cause further deterioration of market prices and
increase the overall risk of the financial system (“systemic risk”). While similar
criticisms have been made periodically for as long as fair values have been used in
GAAP (well over 50 years), the recent volume and political salience2 of these criticisms
is ironic given that in September 2006 the FASB issued FAS 157, Fair Value
Measurements
. This standard contains considerably more comprehensive fair value
measurement guidance than previously existed. It almost seems that the credit crunch was
sent to serve as FAS 157’s trial by fire.

This white paper explains these potential criticisms, indicating where they are
correct and where they are misplaced or overstated. It also summarizes the divergent
views of parties who believe that fair value accounting benefits investors and of those
who believe it hurts investors. Believing in full disclosure, the author acknowledges that
he is an advocate of fair value accounting, especially for financial institutions, but not a
zealot with respect to fair value measurement issues such as those raised by the credit
crunch. Like any other accounting system, fair value accounting has its limitations, both
conceptual and practical. The relevant questions to ask are: Does fair value accounting
provide more useful information to investors than the alternatives (generally some form
of amortized cost accounting)? If so, can the FASB improve FAS 157’s guidance
regarding fair value measurement to better cope with illiquid or otherwise disorderly
markets? In the author’s view, the answer to each of these questions is “yes.”


2

Section II provides useful background information about fair value accounting,
the limited alternative of amortized cost accounting, and the unsatisfying current mixed-
attribute accounting model for financial instruments. This section abstracts from the
difficult issues raised by the credit crunch, because investors cannot properly understand
these issues and their relative importance without first understanding the more basic
issues discussed in this section. Section III summarizes FAS 157’s fair value
measurement guidance, indicating where that guidance does not address the issues raised
by the credit crunch with sufficient specificity. Section IV discusses the aforementioned
potential criticisms of fair value accounting during the credit crunch and provides the
author’s views about these criticisms. Sections V and VI summarize the reasons why
some parties believe that fair value accounting benefits investors while others believe it
hurts investors.

II. Background Information Abstracting from the Credit
Crunch

A. Fair Value Accounting
The goal of fair value measurement is for firms to estimate as best as possible the
prices at which the positions they currently hold would change hands in orderly
transactions based on current information and conditions. To meet this goal, firms must
fully incorporate current information about future cash flows and current risk-adjusted
discount rates into their fair value measurements. As discussed in more detail in Section
III, when market prices for the same or similar positions are available, FAS 157 generally
requires firms to use these prices in estimating fair values. The rationale for this
requirement is market prices should reflect all publicly available information about future
cash flows, including investors’ private information that is revealed through their trading,
as well as current risk-adjusted discount rates. When fair values are estimated using
unadjusted or adjusted market prices, they are referred to as mark-to-market values. If
market prices for the same or similar positions are not available, then firms must estimate
fair values using valuation models. FAS 157 generally requires these models to be
applied using observable market inputs (such as interest rates and yield curves that are
observable at commonly quoted intervals) when they are available and unobservable
firm-supplied inputs (such as expected cash flows developed using the firm’s own data)
otherwise. When fair values are estimated using valuation models, they are referred to as
mark-to-model values.








3

Under fair value accounting, firms report the fair values of the positions they
currently hold on their balance sheets. When fair value accounting is applied fully, firms
also report the periodic changes in the fair value of the positions they currently hold,
referred to as unrealized gains and losses, on their income statements. Unrealized gains
and losses result from the arrival of new information about future cash flows and from
changes in risk-adjusted discount rates during periods. As discussed in more detail in
Section II.C, current GAAP requires fair value accounting to be applied in an incomplete
fashion for some positions, with unrealized gains and losses being recorded in
accumulated other comprehensive income, a component of owners’ equity, not in net
income.3

The main issue with fair value accounting is whether firms can and do estimate
fair values accurately and without discretion. When identical positions trade in liquid
markets that provide unadjusted mark-to-market values, fair value generally is the most
accurate and least discretionary possible measurement attribute, although even liquid
markets get values wrong on occasion. Fair values typically are less accurate and more
discretionary when they are either adjusted mark-to-market values or mark-to-model
values. In adjusting mark-to-market values, firms may have to make adjustments for
market illiquidity or for the dissimilarity of the position being fair valued from the
position for which the market price is observed. These adjustments can be large and
judgmental in some circumstances. In estimating mark-to-model values, firms typically
have choices about which valuation models to use and about which inputs to use in
applying the chosen models. All valuation models are limited, and different models
capture the value-relevant aspects of positions differently. Firms often must apply
valuation models using inputs derived from historical data that predict future cash flows
or correspond to risk-adjusted discount rates imperfectly. The periods firms choose to
analyze historical data to determine these inputs can have very significant effects on their
mark-to-model values.

This issue with fair value accounting is mitigated in practice in two significant
ways. First, FAS 157 and the accounting standards governing certain specific positions
(e.g., FAS 140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities
, which governs retained interests from securitizations)
require firms to disclose qualitative information about how they estimate fair values as
well as quantitative information about their valuation inputs, the sensitivities of their
reported fair values to those inputs, and unrealized gains and losses and other changes in
the fair value of their positions. These disclosures allow investors to assess the reliability
of reported fair values and to adjust or ignore them as desired. Over time, the FASB can
and surely will improve these disclosures and expand them to more positions. Second,
most fair value accounting standards require fair values to be re-estimated each quarter,
and so past valuation errors can and should be corrected on an ongoing and timely basis.






4

In principle, fair value accounting should be the best possible measurement
attribute for inducing firms’ managements to make voluntary disclosures and for making
investors aware of the critical questions to ask managements. When firms report
unrealized gains and losses, their managements are motivated to explain in the
Management Discussion and Analysis sections of financial reports and elsewhere what
went right or wrong during the period and the nature of any fair value measurement
issues. If a firm’s management does not adequately explain their unrealized gains and
losses, then investors at least are aware that value-relevant events occurred during the
period and can prod management to explain further. Until recently, however,
managements have made relatively few voluntary disclosures regarding their fair values.
Fortunately, this appears to be changing as a result of the credit crunch and other factors,
as illustrated by the Senior Supervisors Group’s (2008) survey of recent leading-practice
disclosures.

B. The Limited Alternative of Amortized Cost
Accounting

The alternative to fair value accounting generally is some form of amortized cost
(often referred to over-broadly as “accrual”) accounting. In its pure form, amortized cost
accounting uses historical information about future cash flows and risk-adjusted discount
rates from the inception of positions to account for them throughout their lives on firms’
balance sheets and income statements. Unlike under fair value accounting, unrealized
gains and losses are ignored until they are realized through the disposal, or impairment in
value, of positions or the passage of time. When firms dispose of positions, they record
the cumulative unrealized gains and losses that have developed since the inception or
prior impairment of positions on their income statements.

Amortized cost accounting raises three main issues, all of which arise from its use
of untimely historical information about future cash flows and risk-adjusted discount
rates.

1. Income typically is persistent for as long as firms hold positions, but becomes
transitory when positions mature or are disposed of and firms replace them
with new positions at current market terms. This can lull investors into
believing that income is more persistent than it really is.

2. Positions incepted at different times are accounted for using different
historical information and discount rates, yielding inconsistent and untimely
accounting for the constituent elements of firms’ portfolios. This obscures the
net value and risks of firms’ portfolios.

3. Firms can manage their income through the selective realization of cumulative
unrealized gains and losses on positions, an activity referred to as gains
trading.

5

Issues 2 and 3 are particularly significant for financial institutions. These
institutions typically hold portfolios of many positions chosen to have largely but not
completely offsetting risks, so that the aggregate risks of the institutions’ portfolios are
within their risk management guidelines but still allow them to earn above riskless rates
of return. Amortized cost accounting effectively treats financial institutions’ positions as
if they have no unexpected changes in value until institutions realize gains and losses on
their positions. Financial institutions can easily engage in gains trading, because their
positions are often quite liquid, and because one side of each of their many offsetting
positions typically will have a cumulative unrealized gain while the other side will have a
cumulative unrealized loss. Financial institutions can selectively dispose of the side of
their offsetting positions with cumulative unrealized gains (losses), thereby raising
(lowering) their net income. Because these institutions hold many offsetting positions,
such gains trading can go on for many periods, possibly in the same direction.

In practice, financial report disclosures mitigate these issues with amortized cost
accounting in very limited ways. For example, regarding issues 1 and 2, SEC Industry
Guide 3 requires banks to disclose detailed breakdowns of their amortized cost interest
revenue and expense by type of interest-earning asset and interest-paying liability.
Through careful analysis of these disclosures, investors can attempt to disentangle the
persistent and transitory components of amortized cost interest and to undo the
inconsistent calculation of interest for different positions. This analysis can be difficult to
conduct, however, because it requires investors to estimate from other information
sources the average lives of banks’ different types of assets and liabilities and thus when
these positions likely were incepted and will mature (assuming banks do not dispose of
them before maturity). Moreover, these disclosures are not required for non-banks.
Regarding issue 3, all firms must disclose their realized and unrealized gains and losses
on available-for-sale securities under FAS 115, Accounting for Certain Investments in
Debt and Equity Securities
, which clearly reveals gains trading for these securities.
However, such disclosures are not required for most other financial assets and liabilities
for which gains trading is feasible, although they could be.

Traditional bankers and other advocates of amortized cost accounting often argue
that unrealized gains and losses on fixed-rate or imperfectly floating-rate positions that
arise due to changes in risk-adjusted discount rates (i.e., both riskless rates and credit risk
premia) are irrelevant when firms intend to hold positions to maturity, because firms will
eventually receive or pay the promised cash flows on the positions. Absent issues
regarding the measurement of unrealized gains and losses, this argument is clearly
incorrect. Changes in risk-adjusted discount rates yield economic gains and losses to the
current holders of the positions compared to the alternative of acquiring identical
positions at current rates. For example, when risk-adjusted discount rates rise old assets
yielding interest at lower historical rates are worth less than identical new assets yielding
higher current rates. These old and new assets do not have the same values and should
not be accounted for as if they do. This is true regardless of whether the firms currently
holding the old assets intend to dispose of them before maturity or not.


6

The incorrectness of this argument is most obvious at the portfolio level, which is
the right level to analyze most financial institutions. For example, if interest rates rise,
then traditional banks’ old assets yielding lower historical rates may have to be financed
with new liabilities yielding higher current rates.

Amortized cost accounting usually is not applied in a pure fashion. Assets
accounted for at amortized cost typically are subject to impairment write-downs. These
write-downs can adjust the asset balance to fair value or to another measurement attribute
(typically one that results in an asset balance above fair value). Depending on how
impairment write-downs are measured, some or all of the fair value measurement issues
discussed in Section II.A also apply to these write-downs. Moreover, additional issues
arise for impairment write-downs that are recorded only if judgmental criteria are met,
such as the requirement in FAS 115 and some other standards to record impairment
write-downs only if the impairments are “other than temporary.” Similarly, certain
economic liabilities accounted for at amortized cost (e.g., most loan commitments) are
subject to judgmental accruals of probable and reasonably estimable losses under FAS 5,
Accounting for Contingencies
.

C. The Unsatisfying Mixed-Attribute Accounting
Model for Financial Instruments

GAAP requires various measurement attributes to be used in accounting for
financial instruments. This is referred to as the “mixed attribute” accounting model.

1. Most traditional financial instruments (e.g., banks’ loans held for investment,
deposits, and debt) are reported at amortized cost.

a. As just discussed, financial assets typically are subject to (other-than-
temporary) impairment write-downs. Economic financial liabilities may be
subject to accrual of probable and reasonably estimable losses.

2. A few financial instruments—including trading securities under FAS 115,
nonhedge and fair value hedge derivatives and fair value hedged items under FAS
133, Accounting for Derivative Instruments and Hedging Activities, and
instruments for which the fair value option is chosen under FAS 159, The Fair
Value Option for Financial Assets and Financial Liabilities
—are reported at fair
value on the balance sheet with unrealized gains and losses included in net
income each period.

3. Two distinct hybrids of amortized cost and fair value accounting are required for
other financial instruments.




7

Document Outline

  • ÿ
    • ÿ
    • ÿ
    • ÿ
  • ÿ
      • ÿ
    • ÿ
  • ÿ