To Fair Value, or Not?

Transcription

1 To Fair Value, or Not? Mary E. Barth Stanford University Academic Advisor to the IASB AIMS Conference Bucharest June

2 Fair value debate Fair value is constantly in the news and is a lightening rod for financial reporting debates Raises the question of more fair value, or less? Today, I would like to share my thoughts on the following questions Why are standard setters attracted to fair value, what are the major concerns about its use in financial reporting? Why do we seem unable to resolve the debates? Are academics making matters better or worse? Why is fair value thought to have contributed to the financial crisis? What future challenges do we face? 2

3 Objective of financial reporting Provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity 3

4 Objective of financial reporting Primary users of financial reports Provide resources, but cannot demand information Have common information needs Not management, regulators, or other members of the public Users assess prospects for future net cash inflows Buy, sell, and hold decisions Efficient and effective use of resources by management 4

5 Fundamental qualitative characteristics Relevance: capable of making a difference in users decisions Predictive value; confirmatory value Materiality (entity specific) Faithful representation: faithfully represent the phenomena it purports to represent Completeness, neutrality, free from error (Replaces reliability) 5

6 Enhancing qualitative characteristics Comparability: like things look alike; different things look different Verifiability: knowledgeable and independent observers could reach consensus, but not necessarily complete agreement, that a depiction is a faithful representation Timeliness: information is available to in time to be capable of influencing decisions Understandability: Classify, characterize, and present information clearly and concisely 6

7 Enhancing qualitative characteristics Comparability: like things look alike; different things look different Verifiability: knowledgeable and independent observers could reach consensus, but not necessarily complete agreement, that a depiction is a faithful representation Timeliness: information is available to in time to be capable of influencing decisions Understandability: Classify, characterize, and present information clearly and concisely 7

8 IASB s Conceptual Framework project Conducting project in phases: 1. Objective and qualitative characteristics* 2. Elements of financial statements and recognition 3. Measurement 4. Reporting entity 5. Presentation and disclosure, including reporting boundaries 6. Purpose and status in GAAP hierarchy 7. Applicability to the not for profit sector 8. Entire framework, remaining issues if any *Completed 8

9 Elements Asset: Resource controlled as a result of past events and from which future economic benefits are expected to flow Liability: Present obligation arising from past events, the settlement of which is expected to result in outflow of resources embodying economic benefits Equity: Assets minus liabilities Income (expense): Increases (decreases) in economic benefits during period from inflows or enhancements (outflows or depletions) of assets (liabilities) or decreases (incurrences) of liabilities from increases (decreases) in equity, other than contributions from (distributions to) equity Profit or Loss: Income minus expense 9

10 Measurement What is the most appropriate measurement attribute for a particular asset or liability? Very little in the current Framework on measurement List of measurements used in standards No conceptual basis for choosing among them Large hole in the literature Must use objective, qualitative characteristics, and elements definitions 10

11 What is fair value? An exit price from the perspective of the entity 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 Fair value assumes either sale or use in a business, both based on market participant perspective Entry and exit prices are equal for same item on same date in same market, and buyers and sellers have same information Can be different in different markets look to most advantageous market 11

12 Why fair value? Consistent with objective of financial reporting Provide users with information that assists them in making economic decisions, including predicting amounts, timing, and uncertainty of cash flows Consistent with definitions of assets and liabilities Focus on future inflows/outflows of economic benefits Both suggest current amounts, expectations of future, and current assessments of time value of money/risk Provides an unbiased view of entity s assets and liabilities at the reporting date not its equity 12

13 Why fair value? Possesses qualitative characteristics of accounting information Relevance: capable of helping users make decisions Faithful representation: current measure of assets and liabilities Comparability: same measures for like items across entities Captures economic matches mixed measurement masks them and creates accounting mismatches 13

14 Why not fair value? Estimation error and scope for managing estimates Estimates pervade financial reporting, but fair values are more susceptible Market discipline on fair value estimation is not enough Guidance, disclosure, and education are insufficient Recognizing holding gains and losses in earnings Fear users will not understand; users models are designed to cope with measures we currently report Too much earnings volatility In current crisis, concern about liquidity effects, procyclicality, and bank capital 14

15 Observation Perception that IASB is pushing fair value perhaps even more so than the FASB is incorrect Does the IASB consider it as a possible measurement basis? Yes, for the reasons just explained There is no hidden agenda to increase its use FASB financial instruments ED is a counterexample FASB is committed to fair value for all financial instruments, but IASB is not IFRS might have more fair value than US GAAP, but only in particular areas such as biological assets and permitting asset revaluations 15

16 Lack of measurement concepts Key problem is no measurement guidance in the CF As a result, measurement decisions are ad hoc and inconsistent There are 27 different measurements used today; not just historical cost and fair value Clearly not comparability We do not understand why we use the measurements we use; people make up rationales for what is best in any particular situation It is crucial that we move forward on this chapter, and crucial we not be afraid of the answer 16

17 Are academics making matters better or worse? Regarding research, there is a considerable literature on fair value accounting Fair values are relevant and reliable enough to be reflected in investors valuations Changes in fair value of liabilities are relevant to investors Managers opportunistically exercise discretion, but it never swamps relevance and reliability and also is evident for modified historical cost Fair value estimation error magnifies in income because income is changes in fair value estimates, which is true of all estimates Fundamental analysis research acknowledges the use of modified historical cost is a key reason for such analysis 17

18 Are academics making matters better or worse? Regarding teaching, many are out of date and think Historical cost is one measurement basis and is reliable Reliability = precision Matching and conservatism are principles Uniformity is comparability Objective of financial statements is use in contracting Most are not teaching valuation of assets and liabilities (differs from equity valuation in accounting) Academics should be at forefront of thought and practice; we are responsible for educating next generation 18

19 Fair value and the crisis? What is the line of reasoning linking fair value to the financial crisis? Mortgage defaults resulted in impairments Regulatory capital requirements resulted in asset sales Asset sales drove down prices procyclicality ABX level 2 prices reflect distress sales and hence are low estimates of asset values Fair value accounting made banks recognize these assets at these too low prices 19

20 Fair value and the crisis? I hope none of us accepts this Perhaps more transparency of asset securitizations and derivatives could have helped during the crisis, miaculpa But crisis was about impairments, not unrealized gains Most bank assets are not at, or impaired to, fair value Even for those at fair value, why would managers perceived values have provided better information than market values? Besides, regulators could have undone financial reporting if it jeopardized the stability of the financial system, and did so in some cases 20

21 Fair value and the crisis? What about procyclicality? Responsibility of banking regulators, not accountants Prudential filters generally neutralize unrealized fair value gains and losses on AFS securities Prudential filter relating to effects of own credit risk on liabilities exacerbates procyclicality Decreases (increases) equity in periods of decline (growth) Regulatory levers can mitigate procyclicality without impairing information to capital markets, which can undermine market discipline Interesting that no one complained about fair value accounting when the housing bubble was forming 21

22 Challenges for the future Financial world has witnessed large advances in markets, transactions, arrangements, and instruments Accountants need to take a leadership role in providing relevant information to investors that is the objective of financial reporting Embrace innovations in transactions and markets, not shy away from them The world does not stand still; neither can we Accountants should be the experts, and not give up our franchise to others If fair value is a better answer, we should embrace it 22

23 Thank you! 23