BY MARCO TROMBETTA
Fair value or not fair value: The loan is the question
Let’s Look at two everyday situations.
in one, a bank lends money to someone to buy a house or
to start a new business. in the second, a company raises debt
financing to finance a new investment.
at first glance, these two situations seem pretty common
and standard. Consequently, the general public could think
that the accounting for these situations should be pretty un-
controversial and straightfor ward.
However, anyone who is familiar with recent accounting
debates is aware that this is far from being the case. These are
two of the most controversial items when the issue of account-
ing for financial instruments is examined. Moreover, they are
at the heart of the conflicting areas of the convergence process
put in place by the Financial accounting standards Board and
the international accounting standards Board, which is due
to be completed by 2011.
two official documents have recently been released on
the subject. in november 2009, the iasB issued international
Financial reporting standard 9, Financial Instruments, the
new international standard on financial instruments, which
established the new rules to classify and account for financial
assets. For financial liabilities, the old ias 39, Financial Instruments: Recognition and Measurement, is still the valid standard. on the other side of the atlantic, in May, FasB issued
an exposure draft on Accounting for Financial Instruments
and Revisions to the Accounting for Derivative Instruments
and Hedging Activities.
These documents contain important areas of disagreement
on how to account for financial instruments. in particular, the
two documents openly disagree in prescribing how to account
for the situations described above.
THE CRISIS AND FAIR VALUE
accounting for financial instruments has always been controversial. ias 32 and ias 39 were already the most controversial
standards in the debate that preceded the official endorsements of international accounting standards by the european
union in 2005.
However, the financial crisis that began in 2007 further fueled the debate. at its heart lies the question of whether we
want to account for financial instruments at historical cost or
fair value. Many commentators have argued that the impact
of the financial crisis on the markets was aggravated by the
use of fair value accounting.
was this the case?
on a theoretical basis, the argument can be solidly defended. an article by Guillaume Plantin of the London Business school, Haresh sapra of the Booth school of Business,
and Hyun song shin of Princeton university, published in
the Journal of Accounting Research in 2008, has been fre-
Professor Marco Trombetta is vice dean of research at IE
Business School in Madrid, Spain.
quently quoted to advocate this argument. in that article,
the authors model a market where trading returns are also
determined based, at least partially, on the behavior of the
rest of the market and not only on the intrinsic feature of the
in such a setting, fair value accounting may lead to high
inefficiencies because of a sort of snowball effect that creates
artificial volatility. This is true in particular when the assets
traded are senior, illiquid and long-lived — three features
shared by many of the so-called toxic assets involved in the
crisis. More generally, fair value accounting, by creating a
feedback-loop effect from the market price to the accounting system, can induce fire sales of assets that again affect
the market price. The final consequence is a vicious circle
that can potentially amplify any initially small outside shock
From an empirical point of view, it has been difficult to
sustain this theoretical argument. Christian Leuz of the Booth
school of Business and Christian Laux of Goethe-university
Frankfurt provide a thorough analysis of the actual working
of fair value accounting rules in the u.s. to provide evidence
against this idea. They show that most of the assets that were
accounted at fair value by banks before and after the start of
the crisis were actually so-called Level 3 fair value assets. This
means that their valuations were isolated from the behavior
of the market prices and were conducted by using an internal
model. They also provide a comprehensive review of other
academic studies that question the empirical relevance of
the theoretical vicious circle argument.
However, the debate about accounting for financial instruments has certainly played an important role in the drafting
of the two recent regulatory documents.
ACCOUNTING AND FINANCIAL DECISION-MAKING
a related aspect of the debate has to do with the question of
whether accounting regimes are “neutral” or have the power
to influence the investment decisions of financial institutions.
This question was addressed in a recent theoretical paper that
i developed together with silviu Glavan of the university of
navarra. we show that if accounting numbers are used as
the contractual basis to distribute returns among shareholders, then the portfolio chosen by that financial institution is
determined by the adopted accounting regime.
in particular, fair value induces a more conservative (less
risky) portfolio choice than historical cost accounting. is this
good or bad? it depends on the ultimate objective of the regulators. if the aim is to reduce the level of risk in the system,
then this is a desirable outcome.
However, in terms of consumption smoothing over time
(an important aspect of the role played by the financial institutions in the system), the fair value outcome can be more
inefficient than the historical cost outcome.
From an empirical point of view, again, it is difficult to es-
tablish a conclusive result. However, we can use europe as a
test. we can interpret the shift in 2005 from previous national
standards to iFrs as a move towards a more extensive use
of fair value. Looking at the resistance voiced by financial
institutions before iFrs adoption in europe, that seems to
be how it was perceived in the financial world.
we studied a sample of european banks and analyzed the
composition of their portfolios before and after 2005 and
found preliminary evidence in favor of our theoretical pre-
dictions: The proportion of risky assets diminished after the
adoption of iFrs.
in summary, academic research on accounting for financial
instruments gives us a couple of insights.
First, the choice of the accounting regime for financial in-
struments may have real effects, but they seem to be more
evident at the micro level of portfolio choice than at the mac-
ro level of the overall stability of financial markets. in other
words, different accounting regimes may affect the composi-
tion of the investment choices made in the markets, but they
are less likely to play an active role in the possible destabiliza-
tion of the markets.
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