5/2008: AICPA views on fair value accounting

The Role of Fair Value Accounting in the Subprime Mortgage Meltdown
Three opinions in the May issue of AICPA's Journal of Accountancy

First the view "Both Sides Make Good Points" by Michael R. Young

We’re all familiar with what happened. This past summer, two Bear Stearns funds ran into problems, and the result was increasing financial community uncertainty about the value of mortgage backed financial instruments, particularly collateralized debt obligations (CDOs). As investors tried to delve into the details of the value of CDO assets and the reliability of their cash flows, the extraordinary complexity of the instruments provided a significant impediment to insight into the underlying financial data.

As a result, the markets seized. In other words, everyone got so nervous that active trading in many instruments all but stopped.

The practical significance of the market seizure was all too apparent to both owners of the instruments and newspaper readers. What was largely missed behind the scenes, though, was the accounting significance under Statement no. 157, which puts in place a “fair value hierarchy” that prioritizes the inputs to valuation techniques according to their objectivity and observability (see also “Refining Fair Value Measurement,” JofA, Nov. 07, page 30). At the top of the hierarchy are “Level 1 inputs” which generally involve quoted prices in active markets. At the bottom are “Level 3 inputs” in which no active markets exist.

The accounting significance of the market seizure for subprime financial instruments was that the approach to valuation for many instruments almost overnight dropped from Level 1 to Level 3. The problem was that, because many CDOs to that point had been valued based on Level 1, established models for valuing the instruments at Level 3 were not in place.
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[W]hen subprime instruments were trading in active, observable markets, valuation did not pose much of a problem. But that changed all too suddenly when active markets disappeared and valuation shifted to Level 3. At that point, valuation models needed to be deployed which might potentially be influenced by such things as the future of housing prices, the future of interest rates, and how homeowners could be expected to react to such things.
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Still, the subprime experience also demonstrates that there are two legitimate sides to this debate. For the difficulties in financial markets were not purely the consequences of an accounting system. They were, more fundamentally, the economic consequences of a market in which a bubble had burst.

And advocates of fair value can point to one aspect of fair value accounting—and Statement no. 157 in particular—that is pretty much undeniable. It has given outside investors real-time insight into market gyrations of the sort that, under old accounting regimes, only insiders could see. True, trying to deal with those gyrations can be difficult and the consequences are not always desirable. But that is just another way of saying that ignorance is bliss.

Sabaziotatos says:

A little too much fence sitting. Young nevertheless offers the useful observation that, when the markets seized up, financial institutions did not have in place robust Level 3 models. See, for instance, Citigroup's comments in its most recent conference call: "The methodology that we use has been refined and the inputs have been modified to reflect current conditions. The two principal refinements and modifications this quarter are the use of a more direct method of calculating projected HPA and a more refined method for calculating the discount rate."

Now, for the view "The Capital Markets’ Needs Will Be Served: Fair value accounting limits bubbles rather than creates them" by Paul B.W. Miller

The key to converging market and intrinsic values is understanding that more information, not less, is better. It does no good, and indeed does harm, to leave markets guessing. Reports must be informative and truthful, even if they’re not flattering.

To this end, all must grasp that financial information is favorable if it unveils truth more completely and faithfully instead of presenting an illusory better appearance. Covering up bad news isn’t possible, especially over the long run, and discovered duplicity brings catastrophe.

Sabaziotatos says:

As with most arguments that defend fair value accounting, the problem here is that Miller asserts that what is required is more information and that fair value accounting provides that information, while ignoring the fact that fair value and mark-to-market accounting by its pro-cyclical nature distorts information. As Plantin, Sapra, and Shin have written: "While the historical cost regime leads to some inefficiencies, marking to market may lead to other types of inefficiencies by injecting artificial risk that degrades the information value of prices, and induces sub-optimal real decisions. ... In this way, the mark-to-market regime generates endogenous volatility of prices that impede the resource allocation role of prices."

Finally, the view "The Need for Reliability in Accounting: Why historical cost is more reliable than fair value" by Eugene H. Flegm

HOW WE GOT HERE
The debate over the need for any standards began with the 1929 market crash and the subsequent formation of the SEC. Initially, Congress intended that the chief accountant of the SEC would establish the necessary standards. However, Carmen Blough, the first SEC chief accountant, wanted the American Institute of Accountants (a predecessor to the AICPA) to do this. In 1937 he succeeded in convincing the SEC to do just that. The AICPA did this through an ad hoc committee for 22 years but finally established a more formal committee, the Accounting Principles Board, which functioned until it was deemed inadequate and FASB was formed in 1973.

FASB’s first order of business was to establish a formal “constitution” as outlined by the report of the Trueblood Committee (Objectives of Financial Statements, AICPA, October 1973). With the influence of several academics on that committee, the thrust of the “constitution” was to move to a balance sheet view of income versus the income view which had arisen in the 1930s. Although the ultimate goal was never clarified, it was obvious to some, most notably Robert K. Mautz, who had served as a professor of accounting at the University of Illinois and partner in the accounting firm Ernst & Ernst (a predecessor to Ernst & Young) and finally a member of the Public Oversight Board and the Accounting Hall of Fame. Mautz realized then that the goal was fair value accounting and traveled the nation preaching that a revolution was being proposed. Several companies, notably General Motors and Shell Oil, led the opposition that continues to this day.

The most recent statement on the matter was FASB’s 2006 publication of a preliminary views (PV) document called Conceptual Framework for Financial Reporting: Objective of Financial Reporting and Qualitative Characteristics of Decision-Useful Financial Reporting Information. It is clear that FASB has abandoned the real daily users who apply traditional accounting to manage their businesses. The PV document refers to investors and creditors only. It mentions the need for comparability and consistency but does not attempt to explain how this would be possible under fair value accounting since each manager would be required to make his or her own value judgments, which, of course, would not be comparable to any other company’s evaluations.

Sabaziotatos says:

Excellent brief overview of the historical development of fair value accounting and the coup carried out by those who place more emphasis on the balance sheet than the income statement (or, say, the cash flow of underlying securities).