Fair Value Accounting, the Financial Crisis, and U'S' Standard Setting

1
Fair Value Accounting, the Financial Crisis, and
U.S. Standard Setting

• Wayne R. Landsman
• Capital Markets Institute
• Rotman School of Management
• University of Toronto
• April 23, 2009

2
Overview

• Introduction
• Background of Fair Value Accounting in U.S.
  Standard Setting
• Are Fair Values Useful to Investors? Evidence
  from research
• Fair Value Implementation Issues
• Fair value accounting and the financial crisis

3
Introduction

• Events surrounding the financial crisis caused
  many to question fair value measurement for
  financial instruments.
• SFAS 157 focus on exit value caused banks to
  sell assets because of writedown to distress sale
  levels
• Procyclicality resulted
• Before addressing this criticism, it is helpful
  to review empirical literature on fair value
  accounting with a focus on highlighting findings
  of interest to practitioners and standard setters
• I begin with brief review of fair value
  accounting and standard setting

4
Fair Value Accounting in Standard Setting

• Fair Value Definition
• FASB defines fair value as the price that
  would be received to sell an asset or paid to
  transfer a liability in an orderly transaction
  between market participants at the measurement
  date
• The objective of a fair value measurement is to
  determine the price that would be received to
  sell the asset or paid to transfer the liability
  at the measurement date (an exit price).
  Objective is to estimate exchange price
• Implicit in this objective is that exchange price
  fully captures an instruments value
• In practice, fair value may not be well defined
  because no active market exists for the asset or
  liability.
• Difficult to disentangle an asset or liabilitys
  fair value from its value-in-use to the entity.
• Implication of this is that the value of a swap
  derivative to a bank does not depend on the
  existing assets and liabilities on its balance
  sheet
• A pretty strong assumption!

5
Fair Value Accounting in Standard Setting

• Applications to standard setting
• US (FASB)
• Disclosure
• SFAS 107 Disclosures about fair value of
  financial instruments
• SFAS 119 Disclosure about derivative financial
  instruments and fair value of financial
  instruments
• Recognition
• SFAS 115 Accounting for certain investments in
  debt and equity securities
• No. 133 Accounting for derivative instruments
  and hedging activities

6
Fair Value Accounting in Standard Setting

• Valuation Techniques
• FASB issued SFAS 157, Fair Value Measurements,
  which describes hierarchy of preferences for
  measurement of fair value
• Level 1 quoted prices for identical assets and
  liabilities
• Level 2 quoted prices for similar assets and
  liabilities
• Level 3 company-based estimates
• Firms should use market prices as model inputs
  wherever possible (e.g., equity prices for inputs
  to B-S model to estimate employee stock options
  fair values)
• Can be constructed using entity-supplied inputs
  (e.g., discounted cash flow estimates) if other
  models employing market inputs are not available

7
Fair Value Accounting in Standard Setting

• Valuation Techniques
• Critics of SFAS 157 express both conceptual and
  practical concerns
• Conceptual Concern exit value may not
  appropriately capture the value of an asset (or
  liability) to a firms shareholders even if an
  active market exists for the asset
• Occurs if significant divergence between V-in-Use
  and exit value. For example, V-in-Use reflects
  how an asset is used in conjunction with other
  assets with which it is combined to generate
  income exit value ignores this interaction.
• Practical Concern Because active markets may not
  exist for an asset or liability, FVs will often
  be based on Level 2 and Level 3 estimates
• Subjective, subject to manipulation, and
  difficult to verify (audit).

8
Fair Values Capital Market Evidence

• Policy question typically addressed is whether
  recognized or disclosed accounting amount is
  relevant to investors and measured with
  sufficient reliability to be incrementally
  informative to investors
• Policy question is often operationalized using
  value relevance regressions, testing for
  incremental association of accounting amount
  under study in explaining cross-sectional
  variation in equity share prices
• Example Landsman (1986) pension study
• MVE a0 a1MVA a2MVL a3PA a4PL

9
Fair Values Capital Market Evidence

• US-based Research
• Investment Securities
• Barth (1994) -- pre-SFAS 115
• Investment securities fair values are
  incrementally associated with bank share prices
  after controlling for investment securities book
  values
• But, mixed results for whether unrecognized
  securities gains and losses provide incremental
  explanatory power relative to other components of
  income
• Could be a lack of reliability of fair value
  estimates or omitted variable bias (fair value
  changes of other balance sheet amounts).

10
Fair Values Capital Market Evidence

• US-based Research
• Investment Securities
• Barth, Landsman, and Wahlen (1995) pre-SFAS 115
• Lends support to the measurement error
  explanation by showing that fair value-based
  measures of net income are more volatile than
  historical cost-based measures
• However, incremental volatility not reflected in
  bank share prices
• Banks violate regulatory capital requirements
  more frequently under fair value than historical
  cost accounting and fair value reg capital
  violations incrementally predict future
  historical cost violations

11
Fair Values Capital Market Evidence

• US-based Research
• SFAS 107
• disclosed investment securities, loans, deposits,
  long term debt fair value estimates
• Barth, Beaver and Landsman (1996), Eccher,
  Ramesh, and Thiagarajan (1996), and Nelson (1996)
• Focusing on BBL, basic model is
• MVE-BVE a0 a1 (FV_ISEC - BV_ISEC)
• a2 (FV_LOANS - BV_LOANS)
• a3 (FV_DEP - BV_DEP)
• a4 (FV_LTDT - BV_LTDT) e

12
Fair Values Capital Market Evidence

• US-based Research
• SFAS 107
• BBL (1996) finds
• ISEC and LOANS fair values incrementally
  informative to their book values
• Loans fair value capture dimensions of default
  and interest rate risk
• Investors discount loans fair value estimates
  made by less financially healthy banks (those
  with relatively low regulatory capital)
• Consistent with investors seeing through attempts
  by managers of less healthy banks to exercise
  discretion when estimating loans fair values

13
Fair Values Capital Market Evidence

• International Research
• UK and Australian GAAP asset revaluations
• Easton et al. (1993) estimates annual return
  regressions for Australian firms (1981-90) and
  finds tangible asset revaluations have
  incremental explanatory power relative to
  earnings and change in earnings
• Rit a0 a1 Eit a2 ?Eit a3 REVALit
  eit
• Barth and Clinch (1998) estimates annual stock
  price regressions for Australian firms (1991-95)
  to determine if financial, tangible, and
  intangible asset revaluations have incremental
  explanatory power relative to earnings and equity
  book value (less book value of revaluated
  assets)
• Pit a0 a1 BVEit a2 Eit a3 REVALit
  eit
• Find investments and intangible revaluations are
  incrementally priced, but those for tangible
  assets are not
• Little difference in value relevance between
  appraiser and director-based estimates --
  potential good news regarding level 3 estimates

14
Fair Values Capital Market Evidence

• International Research
• UK and Australian GAAP asset revaluations
• Aboody, Barth, and Kasznik (1999) examines the
  performance prediction and pricing implications
  of fixed asset revaluations for UK sample
  (1983-95).
• Upward asset revaluations predict higher future
  operating income and cash from operations
• Current year revaluations also positively related
  to annual stock returns (Rit), and current year
  asset revaluation balances are significantly
  positively related to annual stock prices (Pit).
• Relations are weaker for higher debt-to-equity
  ratio firms.
• Consistent with managerial discretion
  (manipulation?) affecting the usefulness of asset
  revaluations made by managers of firms facing
  financial distress pressures.

15
Fair Values Capital Market Evidence

• International Research
• UK and Australian GAAP asset revaluations
• Black, Sellers, and Manly (1998) finds no
  difference in earnings management behavior for
  UK, Australian, and NZ firms (1985-95) for asset
  revaluing and non-asset revaluing firms.
• Evidence consistent with mitigation of incentive
  to time asset sales for earnings management
  purposes if gains/losses are recognized in income
  when assets are revalued and gains on sale are
  based on FV rather than HC.
• Findings do not hold for UK firms pre-93, when
  asset revaluing firms were permitted under UK
  GAAP to include in income gains/losses based on
  HC.

16
Fair Value Implementation Issues

• Estimating FV (exit value) for assets and
  liabilities is relatively easy if they are
  actively traded in liquid markets. Issue is
  complicated if
• Active markets for financial instrument do not
  exist
• Exit value and v-in-use differ substantially, in
  which case it becomes hard to disentangle asset
  values.
• For example, for even a single financial
  instrument with embedded options, values of each
  option depend on inter-related default and price
  risk characteristics
• What does exit value mean in this case?
• US Treasury paid 66 for 100 of bank assets
  under TARP. Where did this level 3 price come
  from?

17
Fair Value Implementation Issues

• Manipulation of Model Inputs
• Relying on managers model estimates of Level 3
  fair values introduces informational asymmetry
  problemsadverse selection and moral hazard
  (information asymmetry also for Level 1 and 2
  estimates)
• Adverse selection
• Market cannot distinguish high and low
  quality firms. E.g., how do investors
  distinguish which banks have relatively healthy
  portfolio of loans and which do not if credible
  information regarding assets quality is
  unavailable

18
Fair Value Implementation Issues

• Manipulation of Model Inputs
• Relying on managers model estimates of financial
  instruments fair values introduces informational
  asymmetry problemsadverse selection and moral
  hazard
• Moral hazard
• Managers will tend to use private information to
  their advantage (manage income to maximize
  compensation -- by manipulating information they
  disclose to securities markets and regulators).
• Evidence that managers cannot resist this
  temptation even in the case of model inputs
  relating to unrecognized ESO expense (ABK, 2006)

19
Fair Value Implementation Issues

• Manipulation of Model Inputs
• If fair value accounting is generally applied for
  financial statement recognition, accounting
  standard setters and securities regulators must
  determine how to balance the benefit of
  permitting managers to reveal private information
  (mitigating adverse selection problem) and the
  cost of managerial manipulation of earnings and
  balance sheet amounts when selecting model inputs
  (moral hazard cost)

20
Fair Value Accountingand the Financial Crisis

• Passage of TARP
• Section 133 required SEC to report back to
  Congress
• SEC held three Roundtables in 4th quarter 2008
• Third focused on
• assessing the role SFAS 157 played in causing
  bank failures,
• the impact of such standards on the quality of
  financial information available to investors
• the process used by the FASB in developing
  accounting standards and the advisability and
  feasibility of modifications to such standards.

21
Fair Value Accountingand the Financial Crisis

• Observations
• Need a strong independent private-sector standard
  setting
• SFAS 157 did not cause banks to writedown their
  assets writedowns were the result of bad
  lending practices
• Investors need to know what bank assets are worth
• SFAS 157 procyclicality role is highly
  overstated.
• Procyclicality results even if no fair value
  problem.
• FASB/SEC September 30 release notes provision for
  level 3
• Accounting standard setting is for investors
  regulation of banks to ensure stability of
  financial system is for bank regulators and
  supervisors.

22
Fair Value Accountingand the Financial Crisis

• SEC Report and the future of fair value
  accounting
• TARP SEC report endorsed private-sector standard
  setting and fair value accounting (including SFAS
  157).
• However, the report also recommends
• Developing implementation guidelines
• Readdressing accounting for financial asset
  impairments
• Ensuring that accounting standards meet the
  informational needs of investors
• Congressional hearings on mark-to-market in
  March
• 2009

23
Fair Value Accountingand the Financial Crisis

• FASB responded by issuing 3 FSPs
• FSP FAS 157-4
• FSP gives companies applying 157 more flexibility
  in determining when a market for a particular
  asset is inactive or market prices can be
  characterized as arising from distressed sales.
• Application of the FSP is likely to lead to
  companies using level 3 fair value estimates
  rather than level 1 market prices.
• Obvious concern with FSP leading to deterioration
  of information about bank asset values provided
  to investors

24
Fair Value Accountingand the Financial Crisis

• FASB responded by issuing 3 FSPs
• FSP FAS 115-2 and FAS 124-2
• FSP requires separate display on the income
  statement of losses related to credit
  deterioration and losses related to other
  market factors.
• However, market-related losses would be recorded
  in other comprehensive income (OCI)i.e., be
  excluded from income by deducting them from the
  total impairment chargeif it is not likely that
  the holder of the security will have to sell it
  prior to price recovery.
• OCI portion likely to be excluded from Tier 1
  capital
• Banks have great discretion in determining what
  hits income and what hits Tier 1 capital.
  Difficult to verify (audit).
• FASB has gotten into the bank regulation business.

25
Fair Value Accountingand the Financial Crisis

• FASB responded by issuing 3 FSPs
• FSP 107-1 and APB 28-1
• This FSP requires additional disclosures about
  fair value, including significant assumptions and
  methods
• Goal is to help investors determine quality of
  fair value information.
• Political Pressure continues
• HR 1909 introduced by US Rep. Steve Cohen on
  April 6, 2009, would require the SEC to suspend
  by rule, regulation or order the application of
  mark-to-market accounting