The routledge companion to fair value in accounting
‘Fair value is a central notion in accounting practice, research and standard setting. This book, whose chapters are authored by top-notch accountants and academics, rolls over each of these dimensions to provide an authoritative and comprehensive analysis of the state-ofart and future developments in this area. I think it is a “must” for those interested in fair value accounting.’ Salvador Carmona, Rector, IE University, Spain. Past President of the European Accounting Association and past editor of the European Accounting Review ‘Perhaps no issue in accounting has been as controversial as fair value. Written from the unique perspectives of leading scholars around the world, this collection explores its far-reaching implications for managers, regulators, and the stability of financial markets. An engaging and accessible foray into the complex world of fair value accounting.’ Karen Nelson, Texas Christian University, USA
The Routledge Companion to Fair Value in Accounting
The concept of ‘fair value’ marked a major departure from traditional cost accounting. In theory, under this approach a balance sheet better reflects the current value of assets and
liabilities. Critics of fair value argue that it is less useful over longer time frames and prone to distortion by market inefficiencies resulting in pro-cyclicality in the financial system by exacerbating market swings. Comprising contributions from a unique mixture of academics, standard-setters and practitioners, and edited by internationally recognized experts, this book, on a controversial and intensely debated topic, is a comprehensive reference source that • •
examines the use of fair value in international financial reporting standards (IFRS) and the US standard SFAS 157 Fair Value Measurement, setting out the case for and against; looks at fair value from a number of different theoretical and practical perspectives, including a critical review of the merits and arguments against the use of fair value accounting; and explores fair value accounting in practice, involvement in the Great Financial Crisis, implications for managerial reporting discretion, compensation and investment.
This volume is an indispensable reference that is deserving of a place on the bookshelves of both libraries and all those working in, studying or researching the areas of international accounting, financial accounting and reporting. Gilad Livne is Professor of Accounting at the University of Exeter, UK. Garen Markarian is Chair of Financial Accounting at WHU, Vallendar, Germany.
Routledge Compa nions in Busin ess, M a nagement a n d Accou nting
Routledge Companions in Business, Management and Accounting are prestige reference works providing an overview of a whole subject area or sub-discipline. These books survey the state of the discipline including emerging and cutting-edge areas. Providing a comprehensive, up-to-date, definitive work of reference, Routledge Companions can be cited as an authoritative source on the subject. A key aspect of these Routledge Companions is their international scope and relevance. Edited by an array of highly regarded scholars, these volumes also benefit from teams of contributors that reflect an international range of perspectives. Individually, Routledge Companions in Business, Management and Accounting provide an impactful one-stop-shop resource for each theme covered. Collectively, they represent a comprehensive learning and research resource for researchers, postgraduate students and practitioners.
Published titles in this series include the following: The Routledge Companion to Air Transport Management Edited by Nigel Halpern and Anne Graham The Routledge Companion to the Geography of International Business Edited by Jonathan Beaverstock, Gary Cook, Jennifer Johns, Frank McDonald and Naresh Pandit The Routledge Companion to Risk, Crisis and Security in Business Edited by Kurt J. Engemann The Routledge Companion to Fair Value in Accounting Edited by Gilad Livne and Garen Markarian For more information about this series, please visit: https://www.routledge.com/RoutledgeStudies-in-Genocide-and-Crimes-against-Humanity/book-series/RSGCH
The Routledge Companion to Fair Value in Accounting
1 Does the usage of fair values increase systemic risks?3 Alan Ball and Andrew Haldane PART I
Standards and conceptual issues23 2 Fair value and the Conceptual Framework25 Andrew Lennard 3 Fair value accounting: a standard-setting perspective41 Michel Magnan and Antonio Parbonetti 4 Have the standard-setters gone too far, or not far enough, with fair value accounting?56 Ken Peasnell 5 Shareholder value, financialization and accounting regulation: making sense of fair value adoption in the European Union73 Vera Palea
Contents Part II
Fair value, risk and financial crisis89 6 Measuring fair value when markets malfunction: evidence from the financial crisis91 Amir Amel-Zadeh and Geoff Meeks 7 Fair value accounting in financial institutions106 Christof Beuselinck and Arnt Verriest 8 Bank risk management – and fair value accounting136 Thomas A. Gilliam and Ronny K. Hofmann 9 The use of fair value accounting in risk management in non-financial firms155 John L. Campbell, Jenna D’Adduzio and Jon Duchac Part III
Development179 10 The history of the fair value term and its measurements181 Martin E. Persson, Frank L. Clarke and Graeme W. Dean 11 The ‘fairness’ of fair value accounting: marking-to-market, marking-to-model and financial reporting management199 Kalin Kolev 12 Let the fox guard the henhouse: how relaxing the three-level fair value hierarchy increases the reliability of fair value estimates214 Ester Chen, Ilanit Gavious and Uriel Haran Part IV
Specific topics229 13 Fair value accounting: a manager’s perspective231 Thomas A. Gilliam and Ronny K. Hofmann 14 Tax-related implications of fair value accounting253 Kay Blaufus and Martin Jacob 15 Fair value accounting and executive compensation274 Gilad Livne and Garen Markarian
16 Fair value and the formation of financial market prices through ignorance and hazard288 Yuri Biondi 17 Fair value accounting: China experience296 Jun Chen and Yong Yu 18 Fair value accounting and family firms312 Pietro Mazzola and Massimo De Buglio Index331
Amir Amel-Zadeh is Associate Professor of Accounting at Saïd Business School, University of Oxford. Among other topics, his research investigates accounting and regulatory issues at financial institutions, particularly in relation to fair value accounting. Amir’s research has been published in leading journals such as The Accounting Review, Review of Accounting Studies and others. He has taught or consulted for the financial services industry in the USA, Europe, Asia and the Middle East and previously worked for Lehman Brothers in London. He received his PhD in Finance from the University of Cambridge. Alan Ball is a former member of the financial stability unit, and senior advisor in the prudential policy division at the Bank of England, and co-chair of the Basel Committee of Banking Supervision working group on Disclosure. He has written extensively on market microstructure, systemic risks, and financial regulation. Christof Beuselinck is Professor at IÉSEG School of M anagement (France) and Lille Économie et Management (LEM). His research specializes in the economic and governance outcomes of multinational corporate reporting. Christof has published in internationally peer-reviewed journals such as the Review of Accounting Studies and the Journal of Corporate Finance. He has been teaching on IFRS and related topics internationally and served as an associate member of the European Commission Sponsored INTACCT program on the effects of IFRS harmonization for European firms. Yuri Biondi is tenured Senior Research Fellow of the National Center for Scientific Research of France (Cnrs – IRISSO) and Research Director at the Financial Regulation Research Lab (Labex ReFi), Paris, France. His research interests include economic theory, dynamic systems analysis as well as accounting theory and regulation. Further information is available at http://yuri.biondi.free.fr/. Kay Blaufus is Professor of Business Taxation at Leibniz University Hannover, Germany. He is a certified tax advisor and received his PhD in 2005 from Freie Universität Berlin with a thesis on the economic effects of fair value accounting. His areas of expertise include tax accounting, behavioral taxation and tax compliance. His research has been published in x
Contemporary Accounting Research, European Accounting Review, Journal of Economic Behavior & Organization and Journal of Economic Psychology. John L. Campbell is Associate Professor and EY Faculty Fellow at the University of G eorgia. He has written multiple research papers on the effectiveness of accounting information and, more generally, on derivative instruments. His work is informed by experience using (and accounting for) derivatives at a bank, a manufacturing firm and as a Big-4 auditor. He routinely interacts with members of the Financial Accounting Standards Board and the Securities and Exchange Commission on topics of interest to standard-setters. Jun Chen is a professor of accounting at the School of Management of Zhejiang University. His research areas include auditing, earnings management, and corporate governance. His work has been published in a variety of academic and practitioner journals. He has served as an ad hoc reviewer for numerous journals and an independent board member for multiple listed companies in China. Jun Chen acknowledges financial support from the National Natural Science Foundation of China [grant number NSFC – 71572181]. Ester Chen is Head of Accountancy in the Accounting and Business Administration Department of the Peres Academic Center. She is also a Certified Public Accountant (Israel). In the past, Ester was the Head of the Professional Staff of ICPAI. Her research interests include accounting regulation, fair value accounting, tax avoidance, earnings management, corporate social responsibility, financial disclosure and venture capital. Frank L. Clarke is Emeritus Professor of Accounting at the University of Newcastle; Honorary Professor of Accounting at the University of Sydney; and has held appointments at the Universities of Newcastle, Sydney, Glasgow, Canterbury (New Zealand) and L ancaster. He is a past editor and currently a consulting editor of Abacus. He is the author or joint author of nine books, numerous articles in refereed and business journals, is a frequent presenter at international conferences and is a contributor to the secular financial press (with Graeme W. Dean). Jenna D’Adduzio is a PhD candidate at the University of Georgia. She researches topics of interest to standard-setters and, in particular, on derivative instruments (and cash flow hedges). She is interested in understanding how capital market participants price the information conveyed by firms’ disclosures and how mandatory disclosure requirements affect the pricing of these disclosures. Massimo De Buglio is Adjunct Professor of Accounting at Bocconi University – Milan. He has worked as a business consultant and chartered accountant. His area of expertise includes IAS/IFRS and Italian GAAP accounting, valuation and M&A. He is also a member of the statutory audit board in family and non-family firms. Graeme W. Dean is Emeritus Professor of Accounting and formerly Head of Discipline of Accounting at The University of Sydney and has held visiting appointments at several overseas universities in Glasgow, Graz, Canterbury, Cardiff, Munich and Frankfurt. He was the sole editor (1994–2009) of Abacus, the fourth oldest and one of the leading Anglo-American accounting academic journals. Graeme has published several books and books of readings and nearly 50 refereed journal articles. xi
Jon Duchac is the Wayne Calloway Professor of Accounting at Wake Forest University. He has taught, researched and consulted on financial reporting issues affecting the financial services industry for more than two decades; working with the investment banking, equity research and corporate financial reporting groups at several large financial institutions. He has testified before the US House of Representatives, the Financial Accounting Standards Board and the Securities and Exchange Commission on a variety of financial reporting topics. In 2007, Jon was selected as a Fulbright Distinguished Chair at the Vienna School of Business and Economics. Ilanit Gavious is Associate Professor of Accounting at the Guilford Glazer Faculty of Business and Management, Ben-Gurion University of the Negev. She serves as the Head of the MBA Program of Ben-Gurion University in Eilat. She also serves as a commissioner at the Israel Securities Authority (Israeli SEC). Ilanit is a certified public accountant. In the past, Ilanit served as Senior Accountant in a Big-4 accounting firm and in a leading commercial bank. Her research interests include fair valuations, earning management and corporate disclosure. Thomas A. Gilliam is Assistant Professor with IE Business School and a former executive from Silicon Valley, where he worked with multinational technology companies including Silicon Graphics, Inc., LG Corp., Xerox Corp. and Telesensory Systems, Inc. At Silicon Graphics, he held the position of Director of Finance and Operations where he was responsible for the financial affairs of a 1.5-billion-dollar computer business. Thomas also managed and co-founded a 100-million-dollar data storage business. Andrew Haldane is Chief Economist at the Bank of England. He is also Executive Director of Monetary Analysis, Research and Statistics. He is a member of the Bank’s M onetary Policy Committee. He also has responsibility for research and statistics across the bank. Andrew has an Honorary Doctorate from the Open University, is Honorary Professor at University of Nottingham, a Visiting Fellow at Nuffield College, Oxford, a member of Economic C ouncil of Royal Economic Society, a Fellow of the Academy of Social Sciences and a Member of Research and Policy Committee at NESTA. Andrew is the founder and Trustee of ‘Pro Bono Economics’, a charity that brokers economists into charitable projects and a Trustee of National Numeracy. Andrew has written extensively on domestic and international monetary and financial policy issues and has published over 150 articles and four books. In 2014, Time magazine named him one of the 100 most influential people in the world. Uriel Haran is Senior Lecturer of Organizational Behavior at the Guilford Glazer Faculty of Business and Management, Ben-Gurion University of the Negev, and a member of the Center for Decision Making and Economic Psychology (DMEP). Uriel’s expertise is in experimental behavioral research. His work focuses on issues of decision-making and behavioral ethics in interpersonal and managerial contexts. Ronny K. Hofmann is Assistant Professor with IE Business School who has significant banking and audit experience. Working with Deloitte & Touche in their IFRS Centre of Excellence and as an assistant manager with KPMG, he specialized in the area financial institutions risk management (FIRM), audit financial services and accounting advisory. Ronny’s focus was on providing reporting advice to audit and non-audit clients on a wide range of transactions, including M&As, IPOs and financial instrument valuations. xii
Martin Jacob is Professor of Business Taxation at WHU – Otto Beisheim School of Management. He received his PhD in 2010 from the University of Tübingen. His research focuses on the effects of taxation on investment and payout decisions, tax accounting as well as corporate tax avoidance. His research has been published in leading journals such as Journal of Accounting and Economics, Journal of Accounting Research, Journal of Financial Economics and Review of Financial Studies. Kalin Kolev is Associate Professor of Accounting at Baruch C ollege – CUNY, having previously served on the faculty of Yale School of Management. His research examines topics in financial accounting and reporting, financial reporting quality and fair value measurement being two of the focal points of his past and ongoing work. Andrew Lennard is Director of Research at Financial Reporting Council, having joined in 1990, after qualifying as a chartered accountant with a major accounting firm. In addition to his contribution to the FRC, he has played a part in the development of the discussion of measurement in the conceptual frameworks of IPSASB and the IASB. He is a graduate of St Andrews University and a Fellow of the ICAEW. Gilad Livne is Professor of Accounting at the University of Exeter Business School. Previously to joining Exeter, Gilad served on the faculties of the London Business School and Cass Business School. He received his PhD in accounting at the University of California, Berkeley. Gilad is also a CPA and worked as an auditor prior to pursuing his academic career. He has been a guest lecturer in several universities including HEC Paris, HEC L ausanne, NES Moscow, Bristol University and University of Lancaster Business School. He teaches financial accounting at all levels and has recently published a textbook on IFRS. His research is broadly within financial reporting and has been published in several accounting and fi nance journals. His research was covered in the FT and BBC as well as in other media. Gilad is a member of several editorial boards of accounting journals. He has also consulted analysts and bankers on accounting and reporting-related issues. Michel Magnan is Professor and the Stephen Jarislowsky Chair in Corporate Governance at the John Molson School of Business of Concordia University. He is also Director of the Desjardins Center for Business Financing Innovation. He holds a PhD from the University of Washington (Seattle). His academic career spans over 30 years. His research and professional interests encompass financial statement analysis, governance, executive compensation, ethics and the environment and corporate disclosure. He was inducted into the Royal Society of Canada in 2014. He served as Chief Editor of Contemporary Accounting Research (CAR), one of the world’s leading accounting academic journals, between 2007 and 2010. He is currently Consulting Editor of CAR and Associate Editor of European Accounting Review, Canadian Journal of Administrative Sciences and Revue française de gouvernance d’entreprise. He has been a member of the Canadian Accounting Standards Board (2011–2017). He is currently a Director and Chair of the Audit and Risk Management committee of D esjardins General Insurance Group, Canada’s third largest property and casualty insurer, as well as a Director of the Institute for the Governance of Private and Public Organizations. Garen Markarian holds the Chair of Financial Accounting at WHU – Otto Beisheim School of Management. As an international scholar specializing in corporate finance and governance, he has taught at IE Business School (Madrid), HEC (Paris), Bocconi (Milan), Concordia (Montreal), xiii
Rice (Houston) and Case Western Reserve (Cleveland). Previously holding the position of First Regional Economic Officer for Western Asia at the United Nations, Garen has extensive experience in research on governance mechanisms, executive compensation, the banking crisis, stock markets and financial statements and valuation. His publications have received awards both from the American Finance Association and the American Accounting Association and were mentioned in the Financial Times and CFO magazine. Beforehand, he was a consultant for Standard & Poor’s ‘Society of Industry Leaders.’ He is currently the academic director of the WHU risk management program partnered with the Stockholm School of Economics. Garen has earned a PhD from the Weatherhead School of Management at Case Western Reserve University. Pietro Mazzola is Full Professor at IULM University, Milan and Adjunct Professor at Bocconi University, Milan. He received teaching and evaluation appointments from several Italian, European and US universities and worked as a strategic and accounting advisor for family and non-family firms. He is co-author of the Milan Stock Exchange listing guide on strategic planning. Geoff Meeks is Emeritus Professor of Financial Accounting and Voluntary Director of Research at the University of Cambridge, Judge Business School. He has previously worked for Price Waterhouse, and Edinburgh University, as Director of Graduate Studies in Cambridge Economics, and as Acting Director of Judge Business School. One theme in his publications is the fragility of accounting numbers – especially those for financial assets and liabilities – in the face of market imperfections. Vera Palea, PhD in finance and accounting at Bocconi University, is Associate Professor in Business Economics at the University of Torino. Her research focus is on the consistency of economic and financial regulations in the European Union with the EU socioeconomic model and constitutional setting. She is a member of international accounting research centers. She has published several papers in leading academic journals. Antonio Parbonetti is Full Professor of Accounting at the University of Padova, Italy. He obtained his Doctorate in Business Administration from University of Pisa. During his PhD program, he was International Visiting Student at the Cardiff Business School and at the Case Western Reserve University (Cleveland). His r esearch interests include board composition, CEO compensation, corporate governance and fair value accounting. He served for three years as a member of a supervisory board of a large bank under ECB supervision. Ken Peasnel is Distinguished Professor of Accounting at Lancaster University Management School. He is the author of five books and over 100 articles, policy papers and official reports on various aspects of accounting and finance. Issues of income measurement and the valuation and recognition of assets and liabilities in financial statements have been major concerns of his research, going back into the mid-1970s and through to present day. His most recent work has focused primarily on issues concerning financial reporting in the banking industry, with particular reference to issues relating to the recognition of assets and liabilities and their basis of valuation, but it also includes studies of the value relevance to equity investors of accounting measurements that affect the majority of listed companies. He was the joint winner with his co-authors Wayne Landsman, Peter Pope and Shu Yeh of the American Accounting
Association Financial Accounting and Reporting Section 2008 Best Paper Award for their Review of Accounting Studies article, ‘Which approach to accounting for employee stock options best reflects market pricing?’ Martin E. Persson is the J. J. Wettlaufer Faculty Fellow and Assistant Professor of Managerial Accounting and Control at the Ivey Business School, and his research is focused on the development of accounting thought. He is particularly interested in people, ideas and institutions from the 1900s as well as classical accounting theory and measurement issues. His research has been published in Emerald’s book series Development of Accounting Thought and in Abacus, Accounting Historians Journal, Accounting History and Meditari Accountancy Research. Arnt Verriest is Associate Professor of Accounting at EDHEC Business School in France and belongs to the Financial Analysis and Accounting Research Centre. He teaches financial statement analysis and advanced financial accounting in various graduate programs. His academic research focuses on fair value accounting in banks, international financial reporting standards (IFRS), corporate governance mechanisms in financial institutions and the design of syndicated loan agreements. Yong Yu is an associate professor of accounting at the McCombs School of Business of the University of Texas at Austin. His research areas include financial analysts, institutional investors, and real effects of financial reporting and disclosure. His recent work has examined the economic consequences of mandatory IFRS adoption and the usefulness of fair value accounting for bank valuation.
We are very pleased to present this book to you. Putting this book together has been a massive challenge, and we have been gratefully assisted by the various contributors. We believe you will find here some original thoughts and perspectives brought to you by thinkers and experts in the field. Given the controversial nature of fair values, we strive to bring you differing points of view representing a balanced societal milieu. The Chief Economist of the Bank of England, a member of the British Financial Reporting Council, a member of the Canadian Accounting Standards Board, a retired CFO of an S&P 500 company and academicians from four continents bring many interesting and sometimes provocative points of view to this collection. We are infinitely grateful to them. The book starts with a reflection on the economic crisis of 2008, a topic that is still very relevant as we write these words. In ‘Does the usage of fair values increase systemic risks?’, two prominent economists, drawing on their experiences, discuss improvements to fair value accounting so that it can better serve market processes going forward. This is followed by four parts. The first part covers issues related to standard-setting. The first chapter in this part, ‘Fair value and the conceptual framework’, discusses the fundamental building blocks as envisioned by theorists, politicians, practitioners and standard-setters in ‘creating’ fair value accounting. This is followed by two chapters, ‘Fair value accounting: a standard-setting perspective’ and ‘Have the standard-setters gone too far, or not far enough, with fair value accounting?’, which provide different points of view, one academic’s and one practitioner’s, with regard to the standard-setting process, the conflicts and the politicization of the process. The first part concludes with ‘Shareholder value, financialization and accounting regulation: making sense of fair value adoption in the European Union’, which discusses fair values as it is seen in the field from a political economist’s point of view. The book turns in the second part to explore how fair value accounting may affect perceptions of risk, with a particular focus on financial institutions. The first chapter, ‘Measuring fair value when markets malfunction: evidence from the financial crisis’, goes deeper into the technical specifics and builds upon the ideas put forth in the first chapter. ‘Fair value accounting in financial institutions’ zooms in on the role of fair value accounting where it probably matters the most. The final two chapters focus on how fair value accounting influences risk management: ‘Bank risk management – and fair value accounting’ discusses
financial institutions and their usage of fair value accounting, while ‘The use of fair value accounting in risk management in non-financial firms’ looks at industrial companies. Part III features some thoughts on the evolution in fair value including a historic perspective in ‘The history of the fair value term and its measurements’, which provides a most concise summary of fair value accounting, origins, uses and applications. The next chapter, ‘The “fairness” of fair value accounting: marking-to-market, marking-to-model and financial reporting management’, explores whether the introduction of fair value accounting has augmented the set of accounting choices that could be exploited by managers. ‘Let the fox guard the henhouse: how relaxing the three-level fair value hierarchy increases the reliability of fair value estimates’ expands on this question to explore behavioral aspects of fair value accounting. Our final set of chapters present specialized topics of interest to those needing to build competency in specific issues. ‘Fair value accounting – a manager’s perspective’ provides a perspective from internal accountants in industrial firms. ‘Tax-related implications of fair value accounting’ looks at taxes, while ‘Fair value accounting and executive compensation’ explores how fair values may affect compensation and managerial incentives. ‘Fair value and the formation of financial market prices through ignorance and hazard’ provides a unique philosophic point of view. The last two chapters, ‘Fair values in China’ and ‘Fair values and family firms’, close the book. The first discusses the usage of fair values in China – the next economic superpower if not already, and the last chapter deals with family firms. The latter presents the unique point of view of the thousands of entities, especially in Europe, that have differing motivations when it comes to the usage and presentation of fair value numbers, that is often lost in a world dominated by large publicly listed institutions. We hope you enjoy reading these chapters! Gilad Livne and Garen Markarian
Prologue A reflection
1 Does the usage of fair values increase systemic risks? Alan Ball and Andrew Haldane
Introduction In 2008, the global financial system experienced a dramatic thunderstorm. Lightning strikes threatened seizure in some financial markets and institutions, and, nearly a decade later, the rumbles of thunder are still discernable. The debate on the causes and consequences of this perfect storm have been subject to considerable debate, but at the center of this storm is, on the face of it, a rather basic question: how should the instruments that make up the financial system be valued? So basic a question ought not to be a matter of life and death. But for a great many financial institutions during this crisis, it was precisely that. The fundamental concept on which this debate hinges is fair value. Like beauty, its meaning lies in the eyes of the beholder. For some, the application of fair value principles risks exposing financial firms to the vagaries of markets. For others, ignoring the signals from financial markets risks creating a financial landscape that is anything but fair. The fair value debate generates electricity in the usually static-free professions of accountancy and regulation. Bankers fulminate at the mere mention. Among Heads of State in some of the biggest countries in the world, accounting standards for derivatives have generated levels of fear and consternation usually reserved for non-financial weapons of mass destruction.
Three phases of fair value So, what lies at the heart of this debate? It is well captured by Preston Delano, US Comptroller of the Currency: …the soundness of the banking system depends upon the soundness of the country’s business and industrial enterprises, and should not be measured by the precarious yardstick of current market quotations which often reflect speculative and not true appraisals of intrinsic worth.1
Alan Ball and Andrew Haldane
Delano was US Comptroller of the Currency in 1938. This provides a clue to the fact that the fair value debate is not a new one. To understand this debate, its origins and undulations, it is worth starting at the very beginning. Although bookkeeping has far earlier antecedents, modern accountancy is believed to have begun in the Italian cities of Genoa, Venice and Florence in the 14th century. It is no coincidence that modern banking emerged at precisely the same time in precisely the same cities. Banks emerged to service rapidly expanding commercial companies, and double- entry bookkeeping became an essential means of recording and tracking who owed what to whom, oiling the wheels of finance. It is no coincidence, too, that the first-known description of accountancy was provided by an Italian, Luca Pacioli, in the late 15th century.2 Pacioli was not your typical accountant. A wandering Franciscan monk, tutor and mathematician, he was a friend, and sometimes collaborator, of Leonardo de Vinci. Although comfortably the less famous of the two, Pacioli is still known today as the father of modern accounting. From those beginnings, double-entry bookkeeping began to spread north within Europe during the Middle Ages: to Germany in the 15th century, Spain and England in the 16th century and Scotland in the 17th century. By the late 18th century, Goethe had called double-entry ‘among the finest inventions of the human mind’.3 Some people are easily impressed. Despite that, the progress of double-entry was surprisingly slow. At the start of the 19th century, there were only 11 Londoners who listed their occupation as ‘accomptants’. The 19th century marked a turning point. In the UK, joint stock companies began to spring up. The Bankruptcy Act of 1831 gave accountants a role in winding-up enterprises, and the Companies Acts of 1844 and 1862 established a legal requirement for companies to register and file accounts. By the end of the century, audit practices were becoming established. The accountant’s role was to provide a true and fair view of a company’s assets and income, as protection for the state (to whom it paid taxes) and investors (to whom it paid dividends). It was these concerns that led to the gradual emergence during the second half of the 19th century of fair value-based accounting conventions in the USA. From the late 19th century, banks’ securities were carried at market values and their fixed assets at ‘appraised values’. In other words, by the early 20th century, fair value principles were widely applied to companies in general and to banks in particular. In many respects, this period may have been the high-water mark for fair value principles. In the USA, this first wave of the fair value debate ended in 1938.4 The backdrop was inauspicious. The first phase of the Great Depression, between 1929 and 1933, saw the failure of a large number of US banks. Between 1933 and 1937, the US economy recovered somewhat, but by 1938, there were fears of a double dip. At the Fed’s prompting, Franklin D Roosevelt called a convention comprising the US Treasury, the Federal Reserve Board, the Comptroller of the Currency and the Federal Deposit Insurance Corporation (FDIC). Its purpose was to determine what should be done with prudential standards to safeguard recovery. This was no ordinary regulatory convention. Marriner S Eccles, Chairman of the Federal Reserve, called it ‘guerrilla warfare’. In one corner were the regulators, the Comptroller of the Currency and the FDIC. Scarred by their regulatory experience, and fearing further bank failures, the Comptroller and the FDIC pushed for high prudential standards, including preservation of fair values for banks’ assets. In the other corner was the Fed. Scarred by their monetary policy experience, and fearing a further collapse in lending, the Fed argued for laxer prudential standards and the abandonment of fair values. Battle commenced. The tussle lasted two months, often played out in public through The New York Times. In the end, the Fed prevailed. On 26 June 1938, Franklin D Roosevelt announced (without so 4
Do fair values increase systemic risks?
much as a hint of irony) the Uniform Agreement on Bank Supervisory Procedures. Banks’ investment-grade assets were to be valued not at market values but at amortized cost. And banks’ sub-investment-grade assets were to be valued at a long-run average of market prices. In the teeth of crisis, and in the interest of macroeconomic stability, the first phase of fair value had ended. This pattern was to be repeated half a century later – the second wave of fair value. Historic cost accounting remained in the ascendancy in the USA from the 1940s right through to the early 1970s. But from the mid-1970s onward, accounting standard-setters began to embrace fair value measurement, first in the context of banks’ portfolios of equities and other marketable securities.5 By the late 1980s, there was widespread recognition that traditional accounting approaches were obscuring the real value of securities and derivatives. US experience during the Savings and Loan crisis in the mid-1980s provided further impetus. Forbearance, including about the valuation of assets and liabilities, was widely believed to have been a cause of the buildup of problems among the thrifts.6 In 1989, Congress passed the Financial Institutions Recovery, Reform and Enforcement Act, tightening valuation standards among banks and bringing them closer to fair values. In the same year, the International Accounting Standards Committee (IASC) commenced a project to assess the measurement and disclosure of financial instruments. These too were to suffer a setback. By 1990, recession had taken hold in the USA, with lending contracting sharply. As in 1938, the US economy was suffering ‘financial headwinds’. As in 1938, the Fed was quick to call for a relaxation of prudential and valuation standards to head off pressures on banks.7 As in 1938, the upshot was a concerted move by the then-President, George H W Bush, relaxing examination and valuation standards.8 For the second time, fair value had been returned to its box. And so, to the present day – the third phase. By 2008, the ranks of ‘accomptants’ had swelled, with numbers of recognized accountants in the UK totaling over 275,000. Yet, the issues raised by the global financial crisis had loud echoes of 1938. Through the 1990s, the main international accounting standard-setters extended the boundaries of fair value. In the USA, this was given impetus by the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991. Widespread use of mark to market was a key ingredient of the prompt corrective action approach embodied in FDICIA. From 1992, it became a requirement among US companies to disclose the fair value of all financial instruments in the notes to their accounts. Toward the end of the 1990s, this move was formalized with financial instruments (derivatives, equity and debt) being included explicitly in the accounts at fair value. In the USA, this followed the adoption of the Statement of Financial Accounting Standard 133 in June 1998. Elsewhere, it followed adoption of the IASC’s International Accounting Standard 39 in January 2001. The banking crisis brought that evolution to a halt. As pressures on banks’ balance sheets intensified, subdued lending growth raised concerns that recovery may be retarded. A debate began internationally on rolling back fair value to arrest this downward trajectory. Once again, central bank governors, politicians, regulators and countries were prominent in their criticism of fair value, leading to fears that fair value was poised to enter the third dip on its roller-coaster journey.
Fair values and market prices What have been the underlying forces leading fair value to be at first lauded, then questioned and periodically abandoned? At the heart of this is the vexed question of whether market prices are a true and fair assessment of value. 5
Alan Ball and Andrew Haldane
In theory, market prices ought to be a full and fair reflection of the present value of future cash flows on an asset. This is the fulcrum of the Efficient Markets Hypothesis (EMH). Market prices, if not perfect, are at least efficient aggregators of information – a one-stop shop for appraising value. This simplicity makes EMH a powerful theory. But its real power is its widespread application in practice. EMH has not just monopolized the finance textbooks; it has also dominated the dealing rooms. If the EMH were to hold strictly, the fair value debate would be uncontentious. Marking of assets to market would be proper recognition of their economic value. In that financial utopia, the interests of accountants, investors and regulators would be perfectly aligned. Accountants would have a verifiable valuation yardstick, investors a true and fair view of their true worth and regulators an objective means of evaluating solvency. Fair value would serve treble duty. In practice, the fair value debate is contentious and has been for at least a century. Through history, accountants, investors and regulators have not always sung in tune. Today, accountants are singing opera Pacioli-style and regulators are rapping at 300 words a minute, while investors are left to whistle. In part, this discord has been blamed on failures of EMH, ‘the precarious yardstick of current market quotations’. It should come as no surprise that fair value principles have faced their stiffest tests at times of crisis – the Great Depression during the previous century and the Great Recession during this. For it is at crisis time that EMH itself faces its stiffest test, perhaps none greater than recently. The heterodox British economist George Shackle observed: ‘Valuation is expectation and expectation is imagination’.9 Imagination, and thus valuation, is apt to run wild at the peak of the boom and trough of the bust. These episodes of overactive imagination, or deviations from EMH, can be grouped roughly three ways. Each has an important potential bearing on financial stability and on the fair value debate: •
‘Excess volatility’: Some of the earliest evidence against EMH focused on the tendency of asset prices to fluctuate more than could be justified by movements in fundamentals – socalled excess volatility. While early evidence focused on the behavior of equity prices, the same tests have now been applied to a wide range of asset markets, including corporate bonds, asset-backed securities and exchange rates.10 There is overwhelming empirical evidence of excess volatility in asset prices. ‘Medium-term misalignment’: Excess volatility, while inconvenient, need not by itself severely distort the functioning of capital markets. Asset prices’ signals might be noisy but correct on average. But there is emerging evidence of asset prices becoming persistently misaligned from fundamentals in a variety of markets including equity, residential and commercial property and corporate bonds.11 ‘Apparent arbitrage’: A third aspect of the failure of EMH is evidence of seemingly pure arbitrage opportunities being sustained by market participants for lengthy periods. Unlike excess volatility and misalignment, these deviations from fundamentals represent riskless opportunities to make profits. They have been evident in past, and in particular in the present crisis.
Ultimately, the importance of these three features is an empirical question. Charts 1 and 2 plot the long-run behavior of the equity market, in the UK from the 1920s and in the USA from the 1860s. These long sweeps of history are revealing about patterns of misalignment and excess volatility. In each case, some metric of fundamentals is needed. A model-based 6