In our paper, Fair Value Accounting for Financial Instruments: Does it improve the Association between Bank Leverage and Credit Risk?, which was recently made publicly available on SSRN, we contribute to the debate on whether financial instruments should be measured at fair value in financial statements. Accounting standard setters have been deliberating the role of fair values for financial instruments for decades. A fair value is the price at which two willing parties would exchange an asset or settle a liability. Starting after the savings and loan crisis in the late 1980s, the Financial Accounting Standards Board (FASB) has increased the extent to which financial instruments are recognized at fair value (see Godwin, Petroni, and Wahlen 1998). In 2010, the FASB proposed to require that all financial instruments be recognized at fair value, with limited exceptions for receivables and payables and some companies’ own debt (FASB 2010). The proposal was controversial, with over 2,800 comment letters submitted, the vast majority of which objected to the fair value measurement of loans, deposits, and financial liabilities. The FASB is redeliberating this project and has tentatively decided that all financial instruments should be measured at fair value except certain debt financial assets and most financial liabilities (including deposits), which would be measured at amortized cost (FASB 2011).

To empirically provide insight on the controversy, we assess whether a fair value leverage ratio can explain measures of a bank’s credit risk better than a leverage ratio based on a mixture of fair values and historical costs consistent with the mixed-attribute model of US Generally Accepted Accounting Principles (GAAP) and a leverage ratio based on even fewer fair values than GAAP, which is consistent with regulatory Tier 1 capital. We focus on balance sheet leverage because it is very commonly used for assessing firm risk. We define a bank’s credit risk as the risk that the bank defaults on its obligations, and we focus on credit risk because understanding a bank’s credit risk is essential to understanding its financial condition.

…continue reading: Fair Value Accounting for Financial Instruments

In Americas Mining Corporation the Delaware Supreme Court affirmed the Court of Chancery’s decision in the Southern Peru Copper litigation in which the Court of Chancery awarded damages of $2 billion and $300 million in attorneys’ fees.

While the damage and fee levels were unprecedented, the Delaware Supreme Court found that the Court of Chancery followed existing precedent and exercised its discretion appropriately in awarding such amounts after the plaintiffs had prevailed in showing that Southern Peru Copper had overpaid to acquire an asset owned by its controlling stockholder. The Delaware Supreme Court affirmed the Court of Chancery’s calculation of the damages award based on the difference between the fair value of the asset and the amount paid. Further, the Delaware Supreme Court found that the Court of Chancery properly used its discretion in awarding the attorneys’ fee as a percentage of the damages award.

…continue reading: Delaware Supreme Court Affirms $2 Billion Damages Award

Delaware courts frequently are called upon to determine the “fair value” of a company’s stock. For a company whose capital structure includes preferred stock with a liquidation preference, there is the question of how to treat that liquidation preference when determining the per-share “fair value” of the common, the preferred, or some other specific class of the company’s stock.

Two recent Delaware Court of Chancery decisions by Chancellor Leo E. Strine Jr. demonstrate that the answer depends on whether the liquidation preference actually has been triggered (or otherwise represents a non-speculative payment obligation), or whether the payout of the liquidation preference is a matter of speculation. Importantly, that determination depends on the specific rights defining the liquidation preference, as set forth in the charter or certificate of designations, and does not necessarily depend on “market realities” that might suggest a discount for common stock relative to the preferred.

…continue reading: Common Stock Under Delaware’s Fair Value Standard

In our paper, The Role of Accounting in the Financial Crisis: Lessons for the Future, which was recently made publicly available on SSRN, we discuss the causes of the financial crisis, with particular focus on the debated role of the relevant U.S. accounting standards, and summarize implications for accountants and accounting regulators based on the effect of these existing rules.

The Great Recession that started in 2008 has had significant effects on the US and global economy; estimates of the amount of US wealth lost are approximately $14 trillion (Luhby 2009). Various causes of the financial crisis have been cited, including lax regulation over mortgage lending, a growing housing bubble, the rise of derivatives instruments such as collateralized debt obligations, and questionable banking practices. In addition to these and many other reasons, we explain two factors that partially contributed to the crisis: certain management incentives and fair value accounting standards.

…continue reading: The Role of Accounting in the Financial Crisis

U.S. and international accounting standards mandate recognition and/or disclosure of fair value information for an increasing number of items. Fair value estimates require judgment, introducing the possibility of biases in measurements, measurers, and/or models. In addition, unanticipated changes in market risk result in realized values differing from fair value estimates. Accompanying the shift to fair value accounting is the emergence of voluntary disclosures in audited financial statement footnotes that alert investors to management’s concerns about the reliability of mandated fair value information. We refer to such disclosures as reliability disavowals (hereafter, disavowals). In our paper, Are voluntary disclosures that disavow the reliability of mandated fair value information informative or opportunistic? forthcoming in the Journal of Accounting and Economics as published by Elsevier, we examine whether disavowals are informative; that is whether they are a truthful revelation by management that their fair value estimates are unreliable. We also consider that managerial opportunism may contribute to—or even solely motivate—the decision to disavow.

…continue reading: Voluntary Disclosures That Disavow the Reliability of Mandated Fair Value Information

In the paper, Accounting Standards and Debt Covenants: Has the “Balance Sheet Approach” Led to a Decline in the Use of Balance Sheet Covenants?, forthcoming in the Journal of Accounting and Economics as published by Elsevier, I examine whether the “balance sheet approach” has led to a decline in the use of balance sheet covenants. Debt contracts, and especially private loan agreements, frequently include accounting-based debt covenants. Many of these covenants require the borrower to maintain a threshold level of some financial ratio or measure. A broad range of financial measures are employed in these financial covenants. Some are written on earnings from the income statement; the borrower may be required to maintain a minimum level of earnings relative to their interest expense (interest coverage) or their total debt (debt-to-earnings). Similarly, covenants are also written on values from the balance sheet; these include covenants requiring a minimum level for the book value of equity (net worth) or a maximum amount of debt in the capital structure (leverage). If the borrower fails to maintain a covenant threshold, the debt enters technical default. In technical default, the creditor has the option to attempt action against the borrower; a common consequence is renegotiation with stricter contract terms.

…continue reading: Accounting Standards and Debt Covenants

In our paper, Value Relevance of FAS 157 Fair Value Hierarchy Information and the Impact of Corporate Governance Mechanisms, forthcoming in The Accounting Review, we use banking firm data from the first three quarters of 2008 to examine two important research questions related to fair value information provided by banks under FAS 157. First, we compare the value relevance of Level 1 and Level 2 fair values to the value relevance of Level 3 fair values. Second, we consider whether the impact of corporate governance on the value relevance of fair values is greater for Level 3 assets compared to Level 1 and Level 2 assets. Under FAS 157, firms are required to disclose fair values of asset and liability types by levels, where levels are based on inputs used to generate fair values: (1) Level 1 (observable inputs from quoted prices in active markets), (2) Level 2 (indirectly observable inputs from quoted prices of comparable items in active markets, identical items in inactive markets, or other market-related information), and (3) Level 3 (unobservable, firm-generated inputs). Thus, fair values are disclosed from most reliable (Level 1) to least reliable (Level 3), with a classification that potentially falls somewhere in the middle (Level 2).

…continue reading: FAS 157 and the Impact of Corporate Governance Mechanisms

In a recently released working paper co-authored with Christian Laux entitled Did Fair-Value Accounting Contribute to the Financial Crisis? we investigate whether there is merit to the claim that fair-value accounting exacerbated the severity of the 2008 financial crisis. The main allegations are that fair-value accounting contributes to excessive leverage in boom periods and leads to excessive write-downs in busts. The write-downs deplete bank capital and can set off a downward spiral, as banks are forced to sell assets at “fire sale” prices, which in turn can lead to contagion as prices from asset-fire sales become relevant for other banks.

We begin our analysis by explaining in more detail how pure mark-to-market accounting can cause problems in a crisis. We then outline extant accounting rules for banks’ key assets, which is different from pure mark-to-market accounting. Extant rules allow banks to deviate from market prices under certain circumstances. In addition, not all fair value changes enter the computation of banks’ regulatory capital. We then examine possible mechanisms through which fair-value accounting could have contributed to the financial crisis, and conclude that it is unlikely that fair-value accounting added to the severity of the financial crisis.

…continue reading: Did Fair-Value Accounting Contribute to the Financial Crisis?

I have recently completed two working papers that address issues related to the adoption of International Financial Reporting Standards (IFRS).

In the first paper, entitled Market Reaction to the Adoption of IFRS in Europe, my co-authors and I examine the European stock market reaction to sixteen events associated with the adoption of International Financial Reporting Standards (IFRS) in Europe. European IFRS adoption represented a major milestone towards financial reporting convergence yet spurred controversy reaching the highest levels of government. We find a more positive stock market reaction for firms with lower quality pre-adoption information, which is more pronounced in banks, and with higher pre-adoption information asymmetry, consistent with investors expecting net information quality benefits from IFRS adoption. We also find that the reaction is less positive for firms domiciled in code law countries, consistent with investors having concerns over enforcement of IFRS in those countries. Finally, we find a positive reaction to IFRS adoption events for firms with high quality pre-adoption information, consistent with investors expecting net convergence benefits from IFRS adoption. Overall, the findings suggest that investors in European firms perceived net benefits associated with IFRS adoption. This paper is available for download here.

In the second paper, entitled Consequences of Voluntary and Mandatory Fair Value Accounting: Evidence Surrounding IFRS Adoption in the EU Real Estate Industry, my co-authors and I examine the causes and consequences of European real estate firms’ decisions to provide investment property fair values prior to the required disclosure of this information under International Financial Reporting Standards (IFRS). We find evidence that investor demand for fair value information—reflected in more dispersed ownership—and a firm’s commitment to transparency increase the likelihood of providing fair values prior to their required provision under International Accounting Standard 40 – Investment Property. We also find that firms not providing these fair values face higher information asymmetry. However, we fail to find that the relatively higher information asymmetry was reduced following mandatory adoption of IFRS. Rather, we find that differences in information asymmetry largely remain. Taken together, this evidence suggests that common adoption of fair value accounting due to the mandatory adoption of IFRS does not necessarily level the informational playing field. This paper is available for download here.

The Financial Times recently published the following op-ed piece of mine, entitled Judgment Too Important to be Left to the Accountants.

Two serious asset bubbles–the dotcom explosion of the late 1990s and the recent dizzying ascension in housing prices–have developed in the US economy within the past decade.

Given their damaging consequences, it is time to look for causes. One area that merits attention is fair value accounting, which was adopted as policy by the accounting profession in the 1990s.

This accounting convention requires financial intermediaries to carry their assets at market values, even if those assets are not being held for trading purposes.

When the dotcoms were in vogue, the assets of securities firms and other equity intermediaries were inflated, just as, more recently, rising housing values made banks and other mortgage lenders look flush. Inflated balance sheets and income statements supported more borrowing and more leverage; suddenly, the markets were awash in liquidity and risk premiums fell to unprecedented levels. It could be argued, then, that fair value accounting was the hothouse in which these bubbles bloomed; when prices are rising this system seems both to stimulate and ride the wave of irrational exuberance.

But matters look much less agreeable when the same asset values are falling. Then, the process works in reverse, and the spiral points downwards.

As assets fall in value, leverage rises, creditors and counterparties demand more collateral coverage, and companies must sell assets that they can no longer finance. Forced asset sales drive down prices, causing further write downs of assets under fair value principles–even for those who are not selling. And so it goes on. The downward spiral is continuing as this is written, and where it stops nobody knows.

Fair value accounting also has a one-size-fits-all quality that mimics the inflexibility of over-regulation. Valuing assets with reference to the market seems reasonable for firms that earn their profits from, say, buying and selling securities. In that case, what the market will pay for the firm’s assets and liabilities at any given time may be a good way to assess its overall value. But what about intermediaries such as commercial banks, which are generally in the business of profiting from cash flows? Does it make any difference to an investor in a bank–an investor who is looking to the bank’s success in corralling cash flows–that the market value of the assets that produce these flows may vary?

Many banks point out that the cash flows on portfolios they have substantially written down are doing just fine. A wooden application of fair value accounting to banks–while it may simplify the work of accountants–seems to do a disservice to bank investors, and even more so bank depositors.

If, as banks claim, fair value accounting is causing commercial banks to appear much weaker than they are in fact, it is creating a financial crisis where a mere slowdown might have been warranted.

Fair value accounting is clearly the reigning orthodoxy among accountants, but is that the right test? Accounting is simply a measurement system. What we want to know determines what and how we measure. Which is more important, the balance sheet or the income statement? Do we want to measure financial strength or earnings per share or cash flows? Is the purpose to inform equity investors or creditors and counterparties? Does one measurement system meet all of these objectives?

Given its impact on institutions and whole economies, common sense suggests that we consider whether one means of measurement is the only one we should be looking at. The world view of accountants at a particular time should not determine the answers to these questions.

It is important to recall the famous remark of Clemenceau that war is too important to be left to the generals.