Fair value accounting is the wrong scapegoat for this crisis

The ongoing financial crisis has revived the longstanding debate about fair value accounting. This policy contribution by Nicolas Véron argues that in times of market disruption, no accounting standards could lead to consensual outcomes, and that fair value remains better than proposed alternatives. Rather than reducing its scope, policymakers should focus on capital requirements standards (Basel II), where the negative effects of Â?pro-cyclicalityâ?? are concentrated.

GASB Statement No. 31: Why No Controversy?

Fair value reporting of investments in the financial statements of commercial enterprises is required under FASB Statement No. 115. The standard created much controversy when issued due to provisions that changes in fair values of certain investments were recognized in the operating statement. A major concern to many organizations was the volatility these recognized, but unrealized, changes in fair value would create in reported earnings. When the GASB issued Statement No. 31 requiring fair value reporting of investments there was little controversy concerning volatility to reported earnings of governmental entities, even though the standard required much broader application of fair value reporting. This study examined a possible explanation for the lack of controversy surrounding fair value reporting in the public sector. An analysis of the financial reports of the major U.S. municipalities provided empirical evidence of the significance of investments earnings to municipal revenues, investment assets to total assets, and the significance of changes in fair values of investments to investment earnings and total revenues. Financial reports and accompanying notes for fiscal years 1994 to 1998 were examined. Results indicate that overall, investments earnings were not a significant component of governmental fund revenues. However, investment earnings were significant for certain governmental fund types. The difference between costs and fair market values of investments also did not appear to be material to most governmental funds. The minimal impact of the fair value reporting on earnings offers a partial explanation for the lack of debate surrounding adoption of fair value reporting of investment by governmental entities

Improving fair value accounting.

The turmoil on international financial markets is proving complex to a degree that few could have anticipated when it initially emerged in the summer of 2007. There is still much uncertainty over the duration and potential impact of this turmoil on the real economy. This episode has revealed a series of flaws in various areas of the international financial system. One issue on which regulators, supervisors and other interested parties are focusing is the application of fair value. In many cases discussions turn on quantitative and qualitative matters geared to improving valuation methods and their implementation, especially when applied to complex financial instruments. There is also in-depth refl ection about what information institutions should provide investors regarding the application of fair value, so that investors may take well-grounded decisions. Another area of the debate on fair value considers to what extent its application affects management and investment decisions, and particularly how it may exacerbate procyclical behaviour by financial markets. To examine the relationship between valuation and procyclicality and to identify some solutions to the perverse interaction of the two, the article discusses the advantages of fair value and its limitations, stressing in particular some of the most relevant ones which have emerged during the current financial turmoil. In addition, it puts forward some ideas that might contribute to improving fair value: the use of reserve valuations and of dynamic provisions. It is argued that they can not only improve fair value accounting but also lessen financial procyclicality.

The Effect of Fair vs. Book Value Accounting on the Behavior of Banks

This paper studies the effect of book versus fair value accounting on a bank's (re)investment behavior, risk of default, investment value, and the need for regulation. Adopting the wide--spread view that fair value accounting reduces the degree of asymmetric information, it shows that fair value accounting increases liquidity. Consequently, it intensifies risk shifting and, therefore, increases the need for regulation and the risk of default. For highly leveraged institutions the increased risk shifting under fair value accounting outweighs an underinvestment of book value accounting and ultimately reduces welfare.fair value accounting, book value accounting, asymmetric information, banking regulation, liquidity

Fair Value Accounting: The Road to Be Most Travelled

Fair value convention has polarized two opposing views – the first, that fair value accounting compounds economic hardship and distortion – and the second, that fair value accounting affords an accurate rendering of the market value of underlying assets and liabilities. This paper intends to clarify some of the underlying arguments by presenting a brief overview of fair value accounting, and the main advantages and disadvantages of using fair value regime. The analysis shows that only certain assets and liabilities are required to be measured at fair value and the degree to which unrealized gains and losses associated with fair value measurement are reflected in the financial statements depends on the intended use of assets and liabilities in question. The two main arguments against fair value accounting – exacerbated procyclicality and increased volatility of the financial statements – are amply counterbalanced by arguments in favour of fair value accounting. The latter includes the significance of limitations associated with historical cost accounting, increased relevance of information presented to investors and lower expected likelihood of earnings management under fair value accounting.fair value accounting, accounting, accounting standards

How does the market price pension accruals?

We use a cross-sectional valuation model that distinguishes between the operating and financial activities of the firm to examine the repercussions of three main alternative measures of pension expense. The GAAP Method recognizes a smoothed net pension expense, the NETCOST Method includes the excess of interest cost over the actual return on pension plan assets, if and only if this number is positive, and the FV Method substitutes the fair value in place of the smoothed pension expense. Three alternative fair value estimates of pension expense are examined: the first includes the expected return on plan assets and fair value other costs; the second includes the actual return on plan assets and net fair value other costs; the third includes the expected and the unexpected return on plan assets, along with net fair value other costs. Results from OLS regressions are consistent with the GAAP Method being relevant while the market appears to value the unexpected return included in the FV Method. Additional analyses from jack-knife (out-of-sample) regressions confirm the OLS findings. Further, we show that the multiples assigned to the alternative measures of pension expense differ based on the funding status of pension plans. The results are robust to various sensitivity checks

An Experiment in the Economic Consequences of Additional Disclosure: The Case of the Fair Value of Unlisted Equity Investments

We investigate the economic consequences of additional disclosure about assets with no active market in terms of liquidity, perception of information reliability and relevance. We use an experimental design: 181 MBA students are asked to value 24 investments. We manipulate the level of disclosure on the fair value of assets (Limited versus Full), the perception of expected profit (Gain versus Loss) and the firm's business risk (Low versus High). In the case of Limited (resp. Full) disclosure, participants are given a point estimate for the fair value of the investment (resp. plus a range of possible fair values). We find that in the Full disclosure situation, participants tend to make an offer more frequently, to bid prices lower than the fair value and to earn a lower return on their investments compared to the Limited disclosure case. These consequences vary with the environment (expected profit and risk).fair value; fair value measurement; disclosure; relevance; reliability; risk; SFAS 157; IFRS 7