ACCOUNTING STANDARDS BOARD

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ACCOUNTING STANDARDS BOARD ROUNDTABLE ON
MEASUREMENT IN FINANCIAL REPORTING Economic
Perspectives on Accounting Measurement Michael
Bromwich 24 April 2006

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Look in a non-analytical way at incorporating
predictions of future including those embodied
in market prices into accounts using a purely
decision making perspective Trick for standard
setters is to incorporate predictions without
allowing too many degrees of freedom for
manipulation of accounting information by
management.
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Very Big Topic
As very large and fast growing literature often
with differences Touch on (i) Reasons for
Fair Value (ii) Problems
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The Meaning of Fair Value
Fair values are estimates of what market
prices without incorporating any transactions
costs will be in the situation of equilibrium.
Strictly no general decision by standard setters
between exit and entry prices in imperfect
markets but generally favour exit prices and FASB
exit prices for existing standards
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Estimates

• They can be based on market prices of identical
  or similar transactions (with adjustment for
  differences), recognised valuation procedures and
  managerial forecasts.

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Fair Values Definitions
FASB
the amount at which an asset (liability) could
be bought(incurred) or sold (settled) in a
current transaction between willing parties, that
is, other than a forced or liquidation sale.
SFAS 133
the price at which an asset or liability could
be exchanged in a current transaction between
knowledgeable willing, unrelated parties. FASB
Exposure Draft on Fair Value Measurement (2004)
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Fair Values Definitions II
IASB
the amount for which an asset could be
exchanged, or a liability could be settled, in a
current transaction between knowledgeable,
willing parties in an arms length transaction .
(IAS 32, Financial Instruments)
Note underlined differences
LatestFASB 2006 Fair value is the price that
would be received for an asset or paid to
transfer a liability in a transaction between
market participants
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Attraction of FVs to standard setters
FV objective- little scope for manipulation
FV reflect market views of the future.
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Characteristics of Markets
Knowledgeable, arms length participants Willing
(motivated to transact) and legally and
financially able to transact with access to all
public information with sufficient expertise and
due diligence Sufficient transactions to
guarantee Equilibrium Orderly transactions not
under duress Deep and liquid markets
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Additional Assumptions for Welfare Maximising
Equilibrium
All price takers no economies of scale Full
knowledge and informationally efficient
markets Complete and perfect markets No public
goods and no externalities Thus informationally
efficient markets not sufficient
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Characteristics of Market Prices

• Reflect views of marginal traders
• Do not measure value to others (rents)
  incorporate monopoly rents
• Asset and liability values are noisy
• Firms revenue cash flow may not reflect
  changes in asset values and liabilities
• Do not reflect private information
• Broad range of imperfections and frictions even
  in ideal markets (monetary items)
• Affected by government policy
• Under or overshoots rational bounds

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Logic of Fair Values I
FASB Arguments Only fair values reflect the
amount, the timing and risk of future cash flows
and other impacting factors as seen by the market
(SFAC no 7.) Values should not be contaminated by
management views as will differ between companies
and therefore the same accounting item will be
valued differently by different companies but
perhaps do not trust management
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Logic of Fair Values II
Allows managers to be judged by how well they
have taken past market opportunities e.g..
Whether have swapped fixed interest loan for
variable one where interest declined but not a
strong argument. Makes management tell it as it
is Consistent with assets and liabilities
approach Works well for some financial assets
and liabilities where markets are deep and liquid
and can be expected not to attract super profits
but see below
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LOGIC OF FAIR VALUES III

• Valuation models in finance say that in perfect
  and complete market in equilibrium, can equate
• economic wealth (V0) (PV of cash flows as seen by
  management)
• With
• stock market value (P0) because all above normal
  profits competed away
• Is what could get for opportunity if sold or pay
  if bought.

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Market Information
Includes markets view of public managerial
estimates therefore to deny this in accounting
seems strange. By no means all managerial
information non- verifiable
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Logic of Fair Values III
In a perfect and complete market in equilibrium,
the value of the firm is equal to its net asset
value evaluated at market prices using all
publicly available information which is fully
impounded in market prices. Here an increase
(decrease) in the market value of the firms net
assets is unanimously preferred (disliked)
irrespective of preferences. Thus, when fair
values of a firms assets and liabilities are
aggregated they yield an objective valuation of
the firm based on its cash flows, risk and timing
(as seen by the market).
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Using assets and liabilities

• Can substitute the market prices for cash-flows
  if are ALL traded in perfect and complete
  markets in equilibruim and are priced at, say,
  10.
• Arguments are based on the relationship
• Accounting equity
• Market Value of intangibles
• Market Value of tangible assets
• Market Value of financial assets
• Market Value of liabilities Market Value of
  Equity
• But here accounting purely representational

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Using assets and liabilities
Information given already known to the market via
the prices of assets and liabilities in the
market and therefore no surprise value. No
indication of super profits- all earn normal
return. No one would pay for this information
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• Where internal goodwill (NPV) exists in
  disequilibrium Accounting equity internal
  goodwill (P0 ) net asset value Market Value
  of Equity therefore accounting alone cannot
  capture value of the firm. ALL ACCOUNTING
  SYSTEMS SECOND BEST
• More generally, P0 acts as bridge between A0 and
  V0 includes differences between information sets
  of stock market and accounting, that is the
  conservative accounting treatment of items like
  assets and liabilities markets, intangibles,
  project NPVs,RD.
• This argument not used by standard setters until
  the Canadian paper.

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Problems
Often such markets do not exist therefore are
simulating them but the results are often
incorrigible, that is no empirical referents
exist. Large scope for managerial
discretion Results in complex standards often
with non-verifiable results. For example ,
impairment, revenue recognition And FV on initial
recognition
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FASB want to use fair values (FV) but have not
considered what this means for non-financial
assets. Presumably investors interested in PVs of
assets and liabilities, as estimated by
management. Thus, FVs substitute market views
(values) for those of management.
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Problems with Fair Values III
Non-financial assets do have economic values but
mainly not reported especially internal goodwill
and intangibles and no guarantee that changes in
Financial Values of financial items correlated
with changes in non-financial assets and even if
there are these correlations are not known. Thus
with FVs for financial items not possible to say
how, if at all, changes affect non-financial
assets. With public information, fully
diversified investors and time additive time
preferences, only items of interest changes in
physical productivity of firm and economy
(ignoring information that generates better
trading)
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Therefore FV for financial items has produced a
black hole in accounts. Theory of second
best problems. Accounting reports are lopsided
or use asymmetric treatment of financial and
non-financial items. Solution would seem to be
the use of some variant of value to the business
or deprival value
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CONCLUSIONS
Use market values also for non-financial items
where legitimate. May capture some internal
goodwill. Allow value to the business reasoning
including value in use where necessary.
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