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!

He will both overview an alternative research design to measuring information risk, as well as discuss results from analysis of Level 1, 2, and 3 fair values in financial firms. Eddie is also planning to discuss related research on fair value adoption in other contexts, including the real estate industry.

The abstract of his paper on information risk follows in its entirety:

Using a sample of U.S. financial institutions, we exploit recent mandatory disclosures of financial instruments designated as fair value level 1, 2, and 3 to test whether greater opacity in financial instrument fair values leads to higher cost of capital. We derive an empirical model allowing asset-specific estimates of implied betas, and find evidence that firms with greater exposure to level 3 financial assets exhibit higher betas relative to those designated as level 1 or level 2. We further find that this difference in implied betas across fair value designations is more pronounced for firms expected to have less informative disclosure environments: those firms with lower analyst following, lower market capitalization, higher analyst forecast errors, or higher analyst forecast dispersion. Overall, the results are consistent with a higher cost of capital for more opaque financial assets, but also suggest that effective disclosures can mitigate opacity across the fair value designations.

I hope you will join us on Wednesday, and remember that you can attend Round Table Discussions in Second Life (instructions here) or on the web at our LIVE page.

***********  UPDATE **************

Due to technical difficulties, we have rescheduled this Round Table Discussion for Wednesday, April 28 at 11 am ET.

Please join us!

***********************************

* UPDATE: You can watch the archived video of this Round Table event here.

I use segments of the House testimony in my class to provide a vivid example of political pressure in standard setting.  I think the Weil article will add a nice follow up to this example.
By the way, all of this is related to the Roundtable for tomorrow on the predictivability of fair value.

Mark Evans of Indiana University will lead our next roundtable discussion, Wednesday March 3rd, 11am ET).  Here is the abstract from his recent paper, written with Leslie Hodder and Pat Hopkins, exploring fair value in commercial banks:

For a sample of commercial banks during 1994–2008, we find that accumulated fair value adjustments for investment securities are positively associated with realized income from investment securities in the following period, suggesting that fair values have predictive ability for future realized income. We also find that our measure of predictive ability appears to be a reasonable proxy for reliability because it varies with traditional proxies for the reliability of reported fair values of investment securities. Furthermore, we provide evidence that the relative ability of fair values to predict reported income is a factor that strengthens the relationship between fair values and the market value of equity for commercial banks. Our results also indicate that market-wide credit risk affects the pricing of fair value information in banks’ market value of equity, suggesting that the value relevance of fair value information is partially dependent on market- or industry-wide factors. Finally, in contrast to prior research, we find that both amortized cost and fair value play important roles in predictive ability and value relevance.

Join us for what should be an interesting conversation.  You can watch on the web here, and get more details on attending in Second Life here.

* Update: you can view  the video of this Round Table event here.

For a sample of commercial banks during 1994–2008, we find that accumulated fair value adjustments for investment securities are positively associated with realized income from investment securities in the following period, suggesting that fair values have predictive ability for future realized income. We also find that our measure of predictive ability appears to be a reasonable proxy for reliability because it varies with traditional proxies for the reliability of reported fair values of investment securities. Furthermore, we provide evidence that the relative ability of fair values to predict reported income is a factor that strengthens the relationship between fair values and the market value of equity for commercial banks. Our results also indicate that market-wide credit risk affects the pricing of fair value information in banks’ market value of equity, suggesting that the value relevance of fair value information is partially dependent on market- or industry-wide factors. Finally, in contrast to prior research, we find that both amortized cost and fair value play important roles in predictive ability and value relevance.

One of the last pages elaborates on the information content of amortized costs:

…[O]ur study provides a direct test of the potentially complementary role of amortized-cost and other information that is disclosed concurrently with recognized fair value information for some items measured at fair value. Our results suggest that fair values are value relevant incremental to amortized cost measures and—in contrast to Barth’s (1994) findings—that amortized cost is incrementally value relevant to reported fair values. We find that the value relevance of fair value is stronger when it has high predictive value, while the value relevance of amortized cost increases when fair values have lower value relevance. These findings support Ryan’s (2008, 8 ) suggestion that disclosed amortized cost information can be incrementally useful in the presence of recognized fair values.

Hmmm…what a great topic for a roundtable!

Stephen Ryan (NYU) joins FASRI to talk about his recent research on the fair value option in the banking industry.  Stephen is one of the most respected accounting academics studying banking and financial instruments these days, so I expect people will have plenty of questions beyond the research study that will form the heart of the discussion. From his web page, we learn that:

Stephen has been actively involved in financial accounting standards setting. He currently serves on the Financial Accounting Standards Board’s Liabilities and Equity Resource and Financial Institutions Advisory groups. Until 2003, he was a member of the Financial Accounting Standards Advisory Council, the advisory body for the Financial Accounting Standards Board. He has also previously chaired the American Accounting Association’s Financial Accounting Standards and Financial Reporting Issues Conference committees. Professor Ryan has served as the editor of the Review of Accounting Studies since 2006.

Definitely take a look at his SSRN author page.

Here is the abstract of the paper we’ll be discussing, with Chi-Chun Liu and Yao-Lin Chang:

We examine the determinants of the timing of and financial instruments involved in banks’ initial fair value option (“FVO”) elections upon their adoption of SFAS No. 159. We focus on regular (in 2008:Q1) adopters of the standard, and distinguish their FVO elections from those of early (in 2007:Q1) adopters. Song (2008), Henry (2009), and Guthrie, Irving, and Sokolowsky (2009) find that early adopters’ elections exploited SFAS No. 159’s transition guidance to manage their accounting numbers. These studies provide essentially no evidence that either early or regular adopters complied with the standard’s intent that FVO elections remedy accounting mismatches for economically offsetting positions. In contrast, we hypothesize and provide evidence that regular adopters complied with that intent, having learned from guidance the SEC and others provided about that intent and from the scrutiny early adopters’ FVO elections received. Specifically, we predict and find that variables related to accounting mismatches explain regular adopters’ FVO elections but not early adopters’ elections. We predict and find that variables related to the management of accounting and regulatory capital numbers explain early adopters’ FVO elections but not regular adopters’ elections.

We also examine banks’ initial FVO elections for the three most frequently elected types of financial instruments: AFS securities and debt for early adopters and loans held for sale for regular adopters. We provide four distinct economic and accounting reasons why banks’ FVO initial elections for AFS securities and debt were both amenable to exploitation of SFAS No. 159’s transition guidance and likely to create accounting mismatches, whereas banks’ initial FVO elections for loans held for sale were both not amenable to exploitation of the standard’s transition guidance and likely to remedy accounting mismatches. Based on these reasons, we predict and find that regular adopters’ FVO elections for loans held for sale remedied accounting mismatches and did not exploit SFAS No. 159’s transition guidance. We predict and find the opposite for early adopters’ FVO elections for AFS securities and debt.

Our findings are consistent with regular adopters’ FVO elections, particularly for loans held for sale, complying with SFAS No. 159’s intent. Our findings are broadly consistent with Henry’s (2009) evidence that some early adopters rescinded or revised their FVO elections because of informal mechanisms that arose to help firms interpret and implement SFAS No. 159.

I hope you will join us on Tuesday to hear Stephen’s thoughts, and remember that you can attend Round Table Discussions in Second Life (instructions here) or on the web at our LIVE page.

As a quick reminder, the IASB reached a tentative decision in the revenue recognition discussion paper that onerous contracts (ie, those for which the expected remaining costs exceed the carrying value of that liability) would be measured at cost. The recently re-exposed IAS 37 proposes that onerous contracts be measured as follows:

36A An entity shall measure a liability at the amount that it would rationally pay at the end of the reporting period to be relieved of the present
obligation.

36B The amount that an entity would rationally pay to be relieved of an obligation is the lowest of: (a) the present value of the resources required to fulfil the obligation, measured in accordance with Appendix B; (b) the amount that the entity would have to pay to cancel the obligation; and (c) the amount that the entity would have to pay to transfer the obligation to a third party.

When I first read this guidance, I thought for sure that the boards had chosen a different measurement approach for onerous contracts in IAS 37 than for onerous contracts in revenue recognition. Specifically, the IAS 37 approach would include a margin that a third party would charge on top of its own costs if the price that third party charged was less than the entity’s own expected costs. In other words, the proposed new IAS 37 approach would be more akin to an exit price for the liability. This definitely would have been at odds with the proposed accounting for onerous contracts under the revenue recognition model. But then I read just a little bit further into the IAS 37 exposure draft appendix B:

B8 Some types of obligation will be fulfilled by undertaking a service at a future date. Subject to the exception in paragraph B9, the relevant outflows for such obligations are the amounts that the entity would rationally pay a contractor at the future date to undertake the service on its behalf: (a) if there is a market for a service, the amount is the price that the entity estimates a contractor would charge at the future date to undertake the service on the entity’s behalf. (b) if there is not a market for the service, the entity estimates the amount it would charge another party at the future date to undertake the service. The estimates shall include the costs the entity expects to incur and the margin it would require to undertake the service for the other party.

B9 If the obligation is an onerous contract arising from a transaction within the scope of IAS 18 Revenue or IFRS 4 Insurance Contracts, the relevant future outflows are the costs the entity expects to incur to fulfil its contractual obligations. 

That last paragraph basically says that if the onerous contract is part of a contract with a customer within the scope of IAS 18 or IFRS 4, then the onerous contract is measured only at cost with no additional margin that a third party or the entity itself would charge for those same services. While I can appreciate the simplicity of this approach for most revenue contracts (and in fact, I tend to agree with that approach), this is yet one more instance in which a liability to perform similar services can potentially be measured in the financial statements at a different amount, depending on whether that service is part of a contract with a customer or outside of a contract with a customer. Although I have no alternative to suggest to this mixed-attribute approach for identical liabilities, I can’t help but feel frustrated with the outcome. Ah, if only the things we want to measure in life would make themselves easier to measure—but then again, the value of accounting would probably be greatly diminished if that were the case.

As many of you may have already been aware, it turns out loan loss accounting is anchored firmly in the language of SFAS 5 (ASU 450). As the project update for Credit Quality and the Allowance for Credit Losses points out “Losses are not recognized before it is probable that they have been incurred (referred to as an incurred model), even though it may be probable based on past experience that losses will be incurred in the future.”  I hope 2010 developments move us away from an incurred model and closer to an expected model.

We just finished a great Roundtable with Jim Leisenring from the IASB. We will get the video online as soon as we can. In the meantime, here’s a brief synopsis of what was discussed:

• How do we use standards to eliminate or mitigate transaction structuring? It’s a great goal, and something we’d all like to see, but unfortunately there’s not much we can do about it. Often bright lines invite people to approach the line, and unfortunately substance over form doesn’t fix the problem very often. A good example of this is derivative accounting and embedded cash derivatives.
• Jim discussed his thoughts about “management’s view” and “business models” in disclosure, presentation, and recognition. He also gave some of his reasoning as to why he dissented on IFRS 9.
• Jim listed some things that he thinks are particularly important topics right now including hedging, impairment, consolidations, derecognition, and the distinction between debt and equity. Basically anything that has to do with financial instruments is important right now.
• With regards to convergence of IFRS and US GAAP, the biggest challenge is to get it all done. The challenge will be getting everything done on time but still keeping the quality high. There’s a lot of due process involved and a lot is learned during the exposure time period. The financial crisis has added a new challenge to the timetable, but the 2011 date is still firm.
• There was a good discussion about entry price, value-in-use, and exit price with regards to fair value accounting. Jim said that he believes that exit prices will be the basis of fair value accounting.
• Jim concluded with giving some thoughts about academic research. He recommended two articles, both in the December 1994 issue of Accounting Horizons: (1) “Academic Accounting Research and the Standard Setting Process” by Katherine Schipper and (2) “Accounting Research: On the Relevance of Research to Practice” by James Leisenring and Todd Johnson.

For more information about Jim and his background, visit here.

Additionally follow-up comments on this Round Table event can be found here.

The new International Financial Reporting Standard (IFRS) 9 for financial instruments accounting will “inevitably lead to abuses and accounting arbitrage”, according to Jim Leisenring, a member of the International Accounting Standards Board (IASB).

The first part of the new directive, approved at the end of 2009 and to be expanded to encompass hedging and impairment issues in 2010, would allow the valuation of financial products at amortised cost, rather than fair value, in management of businesses whose “objective… is to hold [it] to collect the contractual cash flows”, regardless of whether they sold it before term.

“IFRS9 doesn’t have a prohibition on how many sales you can make before they stop you valuing products under this option,” Leisenring told Life & Pensions. “How many sales can you have and still say you intend to collect the cash? Can I sell every day?”

The article goes on to discuss Jim’s view of whether abuse of the standard’s objectives would be transparent:

Leisenring acknowledged the argument of defenders of the directive – due to come in force in January 2013 – that abuses would be “obvious” because of a clause forcing companies to acknowledge discrepancies between previous accumulated profit and sale price as a loss, although he said he was “not particularly convinced”.

Maybe Russell Lundholm could find a way to convince Jim one way or the other on the ability of ex-post reporting to mitigate abuses of reporting discretion ex ante.  Lundholm proposed this type of solution in his 2001 Accounting Horizons piece:

[From the Abstract]:  I propose that the financial reporting model be amended to report on the ex post accuracy of a firm’s prior estimates. Doing so will identify firms who have abused their reporting discretion in the past and provide valuable information about the expected credibility of the firm’s disclosures in the present. Firms will also have a greater incentive to make accurate estimates and accruals if they know that opportunistic estimates will be explicitly revealed in the future.

This seems like a good opportunity for laboratory research, and in a few years we might have enough archival data to know how investors respond to firms that repeatedly sell assets they had  “intended” to hold.

Read the full article to see Jim’s views on the “look-through” provision, embedded derivatives and transaction structuring, and hopefully Jim will elaborate on his views at next week’s Round Table discussion.

Such an amendment would shift the power to promulgate accounting standards from the Financial Accounting Standards Board (FASB) to a Systemic Risk Oversight Council, and it would shift the objectives of financial reporting away from providing useful information to investors toward giving bank regulators greater control over accounting standards to achieve stability in financial institutions…..The members of FASC are united in strong opposition to this amendment.  We believe in having generally accepted accounting standards that serve all users including investors and bank regulators.  However, when there is a conflict between these two or more groups, we believe strongly that the needs of investors should be paramount.  This amendment would surely lead to intensely politicized lobbying for accounting standards that would hinder the usefulness of financial reporting for investors.   If regulators are concerned that regulatory capital for banks is poorly measured by accounting standards intended to provide useful information to investors, a far more appropriate approach would be to decouple regulatory standards from financial reporting standards.

Yesterday, the Huffington Post used its typically stronger language to provide its own take:

Instead of treating a fever, suspending accounting standards when the economy is in turmoil is like telling a patient that 104 degrees isn’t so bad and that they’ll be just fine.

The basic facts of the story focus on who is lining up for and against the amendment.

In the midst of what was supposed to be a Congressional push for increased financial regulation and accountability, a powerful coalition of moneyed interests is increasing pressure on Congress to undermine the independence of accounting standards. Banks and major real-estate players are pushing for a system that would actually relax accounting rules in times of economic distress.

….

The group behind the move sent a letter to members of the House Financial Services Committee on Monday, pushing them to back an amendment that will be introduced by Rep. Ed Perlmutter (D-Colo.) and could be voted on as early as Wednesday.

The letter was obtained by HuffPost and is signed by representatives of eight major players that would benefit from looser accounting standards: the American Bankers Association, Commercial Mortgage Securities Association, Council of Federal Home Loan Banks, the Financial Services Roundtable, the National Multi Housing Council, the National Apartment Association, National Association of Home Builders and the Real Estate Roundtable.

I find it interesting that the Huffington Post finds this interesting.  My impression is that HuffPo (as many bloggers call it) is a largely left/progressive outlet that mixes populist outrage with celebrity bikini photos.  Perhaps they are enjoying seeing the ‘monied interests’ battle one another.

UPDATE:  I realize I forgot to quote the “opposition” part promised in the title of this post.  Here it is, from the HuffPo article:

An unusually potent opposition has formed, including Ernst & Young, the American Council for Capital Formation, American Institute of Certified Public Accountants, CalPERS, Center for Audit Quality, Center for Capital Markets Competitiveness, CFA Institute Centre for Financial Market Integrity, Committee on Capital Markets Regulation, Council of Institutional Investors, Deloitte Touche Tohmatsu, Financial Accounting Standards Advisory Council, Financial Executives International, Grant Thornton LLP, Institute of Management Accountants, Investment Company Institute, KPMG LLP and the U.S. Securities and Exchange Commission.